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Fox News tapped me recently to discuss earnings results and debate a recent Morgan Stanley (NYSE: MS) research report on the future of the U.S. economy. What started as a normal day of reporting and commenting on the news turned into a revelation about the state of consumers -- one traders can use to profit.
Morgan Stanley's headline read "No Fed Rate Hike Until 2018," a powerful statement that seemed self-explanatory until I dug deeper. As I read more, I discovered a collection of conflicting assertions that seemed to be pointing to a weak American consumer... but with a twist.
The Morgan Stanley report forecast 2017 U.S. GDP growth at only 1.5%, which is 35% lower than the consensus of 2.3%. The report detailed just how bad things are for American consumers and how many were skimping on expenditures and saving in record numbers.
Morgan Stanley explained that the Federal Reserve would be working overtime just to keep U.S. consumers afloat, and the firm's chief European economist, Elga Bartsch, believed that other competing economists were far too positive in their forecasts. Her somber prognosis didn't even include any bearish surprises (like a Greek crisis) or a more expedited rate hike schedule from the Fed.
The last portion of the report delivered an odd twist. What started as an awfully gloomy prophecy for the future ended with a recommendation to hold onto emerging market stocks and big, multinational American companies like Microsoft (NASDAQ: MSFT) and IBM (NYSE: IBM). Truth be told, it was one of the weirdest reports I have ever read.
But when I examined exactly what was being said, I saw the real message: If interest rates stay low, big multinational companies (like those in the Dow) can prosper despite weakness at the consumer level here in the United States.
We already knew that Europe, Britain, China and other nations are facing economic challenges and weakening their currencies to combat those challenges. The Fed was standing firm and began raising rates... but now it's reversing course.
Some analysts, like those at Morgan Stanley, believe rates won't begin to rise again until 2018, and this is very good news for big companies that do lots of overseas business. Keep in mind that nearly half of the S&P 500's earnings come from outside our borders.
But not all of corporate America should be popping champagne. Small businesses typically subsist solely on domestic spending, not on international commerce, so they desperately need American consumers to spend. Unfortunately, these smaller companies are going to have a much tougher time than blue chips.
Consumer spending accounts for more than two-thirds of GDP, and while recent reports showed an improvement in consumer spending habits in May and June, the future looks murky. Confidence among American adults has actually been trending lower since early 2015.
Meanwhile, the household savings rate has been trending higher since the start of 2016, up to nearly 5.3% of personal income from a low of just 1.9% in July 2005. Higher savings rates combined with flat income growth spell increasing fear among consumers.
The Perfect Way to Play This Trend
As the major indices like the Dow and S&P 500 make record highs, the small-cap Russell 2000 has struggled.
The index tracks 2,000 of the smallest publicly traded stocks. These companies are usually valued between $300 million and $2 billion, with an average market cap of $1.72 billion.
They span all sectors -- from health care and pharmaceuticals to banking, real estate and more -- giving the index broad exposure to every facet of the economy. And unlike the blue-chip companies that make up the S&P 500, which generate nearly 50% of their revenue from foreign sources, the majority of small-cap revenue is derived here in the United States. As a result, the Russell 2000 is highly sensitive to economic fluctuations and real consumer health, which is why it's considered a good barometer of the U.S. economy.
Small-cap companies are more likely to be in their growth stage and can have volatile earnings patterns. They also attract a much larger amount of smaller, domestic money managers and individual investors than their larger counterparts.
Smaller funds and individuals have very different investing styles than major institutions. When big funds sense problems on the horizon, they tend to hold on to their blue-chip stocks, while smaller investors and money managers will move out of their small-cap holdings -- making the Russell first on the chopping block when trouble looms.
Traders can play this trend with the iShares Russell 2000 ETF (NYSE: IWM).
Shorting the fund or buying put options on it could work if IWM drops fast, but given the current market conditions, I don't think either one is the way to go.
Most stocks look very toppy here, but the safety of big, multinational dividend stocks may keep the overall market afloat for a little while longer. That's why I plan to use a different strategy to boost my odds of success.
With the trade I have in mind, IWM could fall, stay flat or even rise another 3% and I can still book an 18% profit by mid-August. That probably sounds too good to be true. It's not, but the trade will require a little more effort on your part. It's not hard to learn... You just have to be willing to step outside your comfort zone a bit.
If you'd like more info on this strategy, I've put together a presentation explaining how it works. I urge you to check it out now since this is exactly the kind of market where increasing your odds can go a long way in creating wealth and, more importantly, reducing risk. You can access the presentation here (for free).
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