Fed Rate Cuts Mean Higher Stock Prices

09/04/2007 12:00 am EST

Focus:

Sam Stovall

Chief Investment Strategist, CFRA Research

Sam Stovall, Standard & Poor’s chief investment strategist, says that when the Federal Reserve cuts interest rates, stocks usually move much higher in the next six and 12 months.

Initially after the Federal Reserve cut the discount rate on August 17, the equity markets responded favorably. The move sent a message to investors that the Fed will do whatever it can to alleviate the lending paralysis brought on by subprime worries. Standard & Poor’s expects the Fed to cut the fed funds rate by 0.25% to 5% at the September 18th meeting of the Federal Open Market Committee.

The rate cut also reminded investors that lower interest rates are one of the strongest share price propellants. As a result, investors may have concluded, using history as a guide, that share prices are now on sale and could soon head higher.

Our advice this time around is, as always: use history as a guide, but not gospel. The rate reduction, in our view, relieved the tension surrounding the credit crisis, but it has not removed the underlying concern surrounding the economy and the stock market.

In the past, when interest rates have started to go “on sale,” investors typically received two-for-one stock price returns. In other words, investors have received 12 months’ worth of stock market advances in only six months. (Discount rates were analyzed from 1945-1982, with the Fed funds rate used since then.)

The Fed began a rate-cutting program 11 times since World War II (12 if you include the August 17th discount-rate reduction.) In the six-month period after the first cut, the S&P 500 advanced an average of 12.3%, three percentage points better than the average 9.0% price increase in all years since 1945. (A bit surprisingly, the market did not rise in each observation, as stock prices fell four out of 11 times.)

Twelve months after the first rate cut, the S&P 500 gained an average 18.8% and posted an increase in 10 of 11 observations. (Lower rates were not enough to stop the market meltdown in 2001.)

But is the S&P 500 the best place to be once rates start tumbling? Since 1980—the consistent starting period for the S&P 500, its growth and value components, the NASDAQ Composite index, small-cap benchmarks, and bond proxy—we see that during the first six months of rate reductions, growth generally beat value, small caps outperformed large caps, and the cyclical groups (as determined by the super sector, NASDAQ) beat them all.

Growth stocks tended to outperform value stocks by an average of 6% and did so two-thirds of the time. We also find that the strongest price performances came from the cyclical consumer discretionary, industrials, and information technology sectors. The energy, telecom services, and utilities sectors posted the smallest average advances.

Finally, while bonds advanced fairly consistently, they usually lagged equities even as rates fell.

S&P continues to recommend an overweighting of the S&P 500 energy and health care sectors, and an underweighting of the consumer discretionary, materials and utilities sectors.

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