Blog : Raising the Penny Stock Upside Outlook

by Ed Zwirn on December 21st, 2013

Why the upside to your 2014 economic outlook should be raised, plus:

Why institutional investors sold the rumor and bought the fact in the week leading up to Wednesday's Fed announcement (see below).

Normally, the third revision of a quarterly gross domestic product estimate is not the stuff that headlines are made of, but the government's latest take on Q3 2013 took investors by pleasant surprise with its finding that recent U.S. economic growth has been greater than previously thought.

The consensus for the GDP report had predicted no significant change would materialize in this latest estimate. Instead, third quarter GDP growth was revised up to 4.1% in the third estimate, up from the second estimate's 3.6%, giving Q3 the best showing since the economy expanded 4.9% in Q4 2011 and showing a sharp pickup from Q2 2013's 2.5% rate of growth.

The evidence from this report shows that this increase is solid from an economic standpoint, driven in large part by a 2.5% growth in real final sales, which is up from the 1.9% gain reported in the second estimate and the largest gain since increasing 3.4% in Q4 2011.

While we now know, from looking at the GDP report, along with the latest jobs update and quotations from the real estate sector, that economic growth began to accelerate in Q3, this begs the question of whether this will be another flash in the pan or the start of a beneficial trend. If the latter, this could mean a much stronger 2014 than the 2-2.5% growth forecast by most economists.

Since stock market investors are betting on the not-too-distant future, the recent bull market is a strong indicator that Q3's accelerating growth trend could continue into 2014. The Dow Jones Industrial Average is so far up 7.2% during Q4, a pickup from the 1.5% rise it managed in the three months which ended Sept. 30. Penny stocks have participated in the Q4 rally, with the Russell 2000 index rising 6.8%, on top of the 9.8% increase it scored in Q3.

In any case, you can look at the latest GDP estimate as a reason to increase your assessment of the possible upside. There are as of this writing no significant threats to the sluggish growth we have been experiencing recently and the possibility has been raised, particularly for penny stocks dependent upon broad domestic economic growth, that we may in fact starting to do much better than that.

Institutional Investors Cash Out                                                                                                                                                                                                                                                                                                                                                                             

It was a case of sell the rumor, buy the fact: Institutional investors cashed out of all major fund groups on a massive scale in the week leading up to the Wednesday afternoon U.S. Federal Reserve announcement that it would be starting modest cuts to its quantitative easing bond buying program in January.

The effect was particularly devastating to actively managed U.S. equity funds, which posted their biggest collective outflow on record during the week which ended Dec. 18, according to EPFR Global. Of these, smaller stocks were the hardest hit, with small- and mid cap funds losing the most investment money.

"Our daily data shows that, in many cases, the bulk of the redemptions occurred before the Fed's decision," said EPFR Global Research Director Cameron Brandt. "So it's not clear yet if it was uncertainty about the decision, or the decision itself, that drove the outflows."

But based on the stock market's reaction, it seems obvious that investors, who have driven the 30 blue-chip stock Dow Jones Industrial Average up 2.2% and the penny stock-rich Russell 2000 index up 2.5% in its wake, must not have been displeased by the decision itself.

The uncertainty having evaporated, we can only assume that these fund outflows will reverse themselves, and in fact have started doing so, if the current pre-Christmas rally is any indication. There remains the possibility of further upward movement for stocks of all sizes in the coming days, at least until volumes trail off for the holidays.

Penny stocks, an investment group which took a beating in terms of fund outflows in the week leading up to the Fed announcement, are therefore well positioned to snap back during the waning days of 2013, assuming that last week's flows are reversing themselves, as seems to be the case.

As I pointed out in my most recent penny stock blog, the current market for everything from penny stocks to blue chips has rallied since the Fed announcement, in large part because it took some of the uncertainty premium out of the investment equation. A whole host of uncertainties had confronted investors in recent months, ranging from war prospects to debt ceiling showdowns, and the Fed's announcement of a $10 billion cut to its $85 billion monthly bond buying program in January has removed a major variable from the macro investment equation.