What the Rate Cut Means for the Market


What the Rate Cut Means for the Market

Expect more volatility, but don't abandon stocks. Instead, go with big, blue-chip companies.

On September 18, film crews were in Washington, D.C., to shoot a spy thriller starring Russell Crowe and Leonardo DiCaprio. But that was nothing compared to the drama unfolding down the street at the Federal Reserve Building, where central bankers met to set the course of interest rates.

Reviews on Wall Street were stellar: Within minutes of the news of a half-point cut in the federal funds rate -- the rate banks charge each other for short-term loans -- to 4.75%, the Dow Jones industrial average soared some 200 points. And it kept on going. The Dow closed at 13,739.47, up 336 points, or 2.5% -- its biggest one-day gain in nearly five years. Standard & Poor's 500-stock index did even better, jumping 2.9%.

History shows that the outlook for stocks is promising after Fed rate cuts. In the 11 times the Fed has started to cut rates since 1945, the S&P 500 has gained 12% in the six months following, on average, according to Standard & Poor's.

But don't spend your capital gains just yet. After four of the 11 initial rate cuts, stocks fell, including in 1990, when the S&P 500 index sank 14% as the economy struggled with a bear market in housing that gutted the S&L industry and a junk-bond meltdown -- a situation eerily familiar to today's housing woes and mortgage-induced credit crunch.


And don't forget the last time the Fed went on a rate-cutting binge: In January 2001, nearly ten months into what would turn into a devastating bear market, stock prices continued to fall for 21 more months.

The question investors need to address is whether the latest Fed cut comes too late to prevent a recession. Brian Bethune, U.S. economist at global Insight, a forecasting firm, pegs the odds of recession at 30%. That may seem low, but Bethune points out that in the early part of a business cycle the risk of recession is less than 5% and at mid-cycle it might be 10% to 20%.

"When you get up to 30%, it's high," he says. He's looking for GDP growth of less than 2% for the next three quarters. (Kiplinger's sees growth of 1% to 2% this year and a slight pickup next year.)

The housing market will still be in a severe downturn a year from now, says Mark Zandi, chief economist at Moody's Economy.com. Falling home prices will, in turn, weigh on consumer spending going into the key holiday season, he predicts.


On the plus side, global growth is fueling demand for U.S. exports, inventories are lean, and corporate balance sheets are strong. And the Fed's half-point cut -- a quarter-point more than many expected -- could well tip the odds in favor of the bulls. "They're the Calvary, heading off a recession at the pass," says S&P chief strategist Sam Stovall.

What's an investor to do? Investors can expect more big swings in the stock market in coming weeks as traders react to each and every nugget of economic news. We wouldn't be surprised to see the market give a little back in coming sessions, nor would we blame anyone for taking some profits on up days, especially as part of a regular portfolio re-balancing.

Certainly, this is no time to bottom fish, especially in home builders, real estate investment trusts or in the stocks of companies that make big-ticket consumer goods, such as cars and appliances, that people can delay buying.

But this is also no time to abandon the market. If the economy were truly on the ropes, stocks, which often presage recessions, would be down 25% instead of within a hair of the summer high, argues Jim Paulsen, chief investment strategist at Wells Capital Management.


He also notes the formation of a handful of new "vulture" funds that specialize in spinning the debt of distressed companies into gold -- reportedly at such mainline shops as Pimco and TCW. That suggests that at least some of the smart money thinks the current credit crisis is overblown.

Investors will do best to focus on big, blue-chip companies with a global presence. Attractive candidates are capital-equipment makers, such as Deere & Co. (symbol DE, $145.86), industrial powerhouses such as 3M (MMM, $91.66) and especially technology companies, which collectively garner 56% of revenues overseas, including IBM (IBM, $116.63), Intel (INTC, $25.41) and Oracle (ORCL, $20.73). These companies have the wherewithal to muscle through any lingering credit crunch. Plus, they'll prosper as overseas sales climb and benefit from a falling dollar, as foreign revenues translate into more greenbacks here.

One encouraging sign: Lehman Brothers Holdings, the first investment bank to report earnings since the collapse of the subprime market, gave investors hope September 18 that the mortgage-backed securities fallout won't be as bad as expected. Earnings fell just 3% in the tumultuous third quarter compared with the same period a year ago; Lehman's stock (LEH) rose 10%, to $64.49.

Look for Morgan Stanley (MS), Goldman Sachs (GS) and Bear Stearns (BSC) to report earnings later this week. Morgan Stanley rose 6% on September 18, to $68.51; Goldman jumped 7%, to $200.50; and Bear climbed 3%, to $119.20.