Rate Cut Is Bullish, but…

10/03/2007 12:00 am EST

Focus: MARKETS

James Stack

President, Stack Financial Management

James Stack, president of InvesTech Research, says monetary easing by the Federal Reserve tends to be bullish, but he still urges caution.

The Fed's easing is historically bullish for the stock market. On average there is a 3:1 ratio of upside potential to downside risk in the stock market, after a second discount rate cut by the Federal Reserve.
 
Over the past 50+ years two-thirds (8 of 12) of the second discount rate cuts have led to double-digit gains within the next six months, while only two experienced double-digit losses. But this still doesn't tell the whole story.

The tight link between monetary policy and the stock market is what prompted the development of our Monetary Exposure Profile (or MEP) in the early 1980s. The MEP tracks Federal Reserve policy by measuring banking liquidity, credit demand, and the trend and momentum of key interest rates, [as well as] global money flows.

Over the years, our MEP has earned a cornerstone position as the primary monetary model used by InvesTech to determine whether the monetary environment is favorable or unfavorable for the stock market. Bear markets invariably start when monetary conditions have turned hostile. 

Our MEP Monetary Model has turned positive-obviously due to the reversal in Fed policy, plus the sympathetic drop in long-term bond yields. So this is bullish, right? The answer is "Yes, but."

And the caveat lies in one major problem. The Fed is not easing as confirmation of a successful "soft landing," but rather in fearful panic of a hard one. What's happening in real estate is deflationary. As prices drop and esoteric mortgages go into default, wealth is being reduced or wiped out. For central banks, potential deflation is their greatest nemesis, simply because it's difficult to control. Once started, all the easing (and interest rate cuts) in the world may not stop the carnage. Often, it just has to run its course.

This is exactly what happened in the popping of the high-tech bubble in 2000. Even with a record 11 Discount Rate cuts by the Fed in 2001, a recession became unavoidable and the stock market didn't hit bottom until October 2002.

No one can say with any degree of certainty whether the Federal Reserve will be able to contain or halt the housing bust. Meanwhile, the current double-top carries a higher risk of a more severe bear market in the event that a market top might be in place.

So, our strategy preference is to wait and watch for more solid evidence of a successful soft landing and initial signs of stability in the housing debacle. Watch out for more new lows in our Housing Bellwether Index (tracked on the home page of our Web site) and use a firm protective stop at 13,000 in the Dow Jones Industrial Average. There are few instances in which the Fed has cut the discount rate twice, and the stock market has still fallen to new six-month lows-[except] when the Fed had lost control and was "pushing on a string."

Subscribe to InvesTech Research here...

Related Articles on MARKETS