A Rate-Cut Bump

S&P: When interest rates fall, optimism (and stock prices) usually rise

Nothing excites Wall Street more than the possibility of a new round of rate cuts by the Federal Reserve.

Stock market history shows that when the Fed started cutting rates, investors typically received a greater than two-for-one stock price return - in other words, more than a year's worth of stock market advances (based on the average annual gain for the S&P 500, since 1945, of 9%) in six months.

Take a look at the accompanying table, which shows price performance for the major stock and bond indices six months after the Federal Reserve started lowering interest rates. (Discount rates were analyzed from 1945 through 1982 and the Fed funds rate thereafter.) Standard & Poor's expects the Fed to make its first rate cut in the summer of 2007.

The Fed has launched 10 rate-cutting campaigns since World War II. In the six months after the first cut, the S&P 500 advanced an average of 11%, two percentage points better than the average price increase in all years since 1945. A bit surprisingly, the market did not rise in each case, as stock prices fell four out of 10 times.

Not shown in the table, however, is that 12 months after the first rate cut, the S&P 500 gained an average of 18.6% and posted an increase in nine of 10 observations (lower rates were not enough to stop the market meltdown in 2001). Since 1980, the starting date for most major indices, we see that during the first six months of rate reductions, growth generally beat value, small-caps outperformed large-caps, and the cyclical groups beat them all. Finally, we note that while bonds advanced fairly consistently, they usually lagged behind equities, even as rates fell.

Digging a little deeper to the sector level, if 2007 is indeed a year when investors look beyond the mid-cycle pause in the economy to the recovery that is widely expected for 2008, they may again embrace cyclical sectors at the expense of the defensive ones.

Looking at data that shows average price performance (and frequencies of outperformance) for the underlying industries from 1945 through 1982, and S&P sector level data thereafter, we found that the strongest price performance came from the cyclical consumer discretionary, industrials, and information technology sectors. The financials, telecom services, and utilities sectors posted the smallest average advances. The highest frequency of outperformance was found in the consumer staples, industrials, and information technology sectors.

Remember, of course, that past performance is no guarantee of future results.

Benchmark Performances Six Months After First Interest Rate Decrease
Periods Analyzed Growth S&P 500 Blend Value Nasdaq R-2000/ S&P 600 Lehman Aggregate
2/5/54-8/5/54 17.9
11/15/57-5/15/58 9.3
6/10/60-12/10/60 -2.3
11/13/70-5/13/71 22.3
12/9/74-6/9/75 39.5 42.3 38.2 40.3 -- 3.6
5/30/80-11/30/80 39.8 27.4 16.5 38.7 40.6 -6.1
11/2/81-5/2/82 -12.1 -4.5 -11.1 -5.4 -4.7 11.6
7/13/90-1/13/91 -2.6 -13.7 -4.3 -22.6 -21.8 6
6/6/95-12/6/95 13.0 15.3 13.2 20.7 16.1 5.6
1/3/01-7/3/01 -11.8 -3.6 -5.1 -6.2 8.7 3.6
Averages 11.0 11.0 7.9 10.9 7.8 4
Averages Since 1980 5.3 4.2 1.8 5.0 7.8 4.1
% Freq. of Advance 40 40 40 40 60 80
% Freq. of Beating “500” 40 NA 20 40 60 60

Source: Standard & Poor's, Federal Reserve. Discount rates used 1954-1982. Fed funds rates used 1990-2001. Daily prices used for S&P 500 and Nasdaq computations. S&P/Barra Growth & Value: month-average prices used through 1991, month-end in 1995, and daily in 2001. Russell 2000: month-end through 1991. S&P SmallCap 600: week ending in 1995; daily in 2001. Lehman Aggregate: month-end total returns through 2001. NA-Not available.

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