Stocks Surge on Big Fed Rate Cut

The FOMC's super-sized half-point easing Tuesday sparked huge gains in equity indexes. But concerns about broader economic slowing persist

With the gusto of Zorro swooping in for a rescue, on Tuesday the Federal Reserve slashed its target for the Fed funds rate by a surprising half-point, igniting the biggest rally U.S. stock indexes have seen all year. Most observers had hoped for only a quarter-point cut, even though talk of the need for more aggressive action has been unrelenting in recent weeks as signs of economic stress beyond the real estate market have mounted.

On Tuesday, the Dow Jones industrial average surged 335.97 points, or 2.51%, higher to 13,739.39, its first 300-plus point gain since October, 2002. The broader S&P 500 index rose 43.13 points, or 2.92%, to 1,519.78. The tech-heavy Nasdaq composite index climbed 70.00 points, or 2.71%, to 2,651.66.

The S&P 500 index has rallied on the same day as a Fed rate cut only six of the last 13 times, Thomson Financial said.

All but one of the 30 Dow components finished higher, with General Electric (GE) vaulting to a five-year high above $41 a share (Boeing Co. [BA] was the sole Dow member to close lower). The Fed's aggressive action was a boon to financials, technology stocks, utilities and homebuilders, with homebuilders perhaps standing to gain the most from lower interest rates.

In cutting the Fed funds rate to 4.75%, the Fed's policy committee said that recent developments in financial markets had increased uncertainty about the far-ranging impact of the housing downturn.

Noting the moderate pace of economic growth during the first half of 2007, the policy statement by the Federal Open Market Committee acknowledged the potential for the tightening of credit conditions to intensify the housing correction and to restrain economic growth more generally.

"Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time," the FOMC said.

The Fed's policy committee also cut the discount rate by 50 basis points to 5.25%. While the decision to ease the Fed funds rate was unanimous, it was accompanied by renewed warnings about inflation, which had disappeared from the Fed's statements in mid-August after the magnitude of the credit crisis moved to the fore of the Fed's concerns.

A report showing a bigger-than-expected drop in producer prices in August sent equity prices higher when the markets opened, with further support coming from a strong earnings report from Lehman Brothers Holdings (LEH), the first of the big investment banks to post results since the seizing up of credit markets. That fanned hopes that the financial sector would be able to weather the subprime mortgage meltdown with smaller losses than had been feared.

Though financials seemed to be back in favor on Tuesday, Barbara Walchli, who manages the $29 million Aquila Rocky Mountain Equity Fund in Phoenix, said she plans to stay underweighted in financial stocks for a while, as they will have to digest some of the mispriced risk they've benefited from in recent years.

The companies that will benefit most from the Fed's move are smaller-cap ones that are either in the developmental stage and in need of loans to drive investments or those with greater than 50% debt-to-capital ratios whose anxiety levels have risen as credit has tightened, Walchli said.

Howard Applebaum, executive vice-president and senior lending officer at Sterling Bancorp (STL) said the Fed rate cut would "take the sting out of what our borrowers would need to run their businesses." His customers tend to be smaller service companies, distributors and importers that rely on loans to expand their business and aren't able to pass on higher borrowing costs to their clients.

But he added that "if you want people to spend more, you need further cuts."

He said he doesn't expect the half-point cut to alter his customers' borrowing habits, but it will ease their concerns and perhaps allow business owners to pay themselves a bigger salary when they may have been scrimping.

Leading the economic news on Tuesday, the PPI fell 1.4% in August, after a 0.6% gain in July, while the August core index rose 0.2%. The data may have given the Fed more room to lower interest rates, but the fact that the drop was driven by a 6.6% plunge in energy prices makes the case for easing inflation less credible, given the spike in oil prices to record highs over $80 a barrel in September.

Foreclosures leaped 36% to 243,947 in August from July, and were up 115% from a year ago. REOs, or bank repossessions, accounted for a higher percentage of the foreclosures, according to CNBC Business News. The growth in foreclosures is being driven by seven states, including Florida and California.

The Housing Market Index fell for a seventh month in a row by two points to 20 in September, tying its record low from January, 1991. The huge buildup in inventory has builders concerned about consumer demand for new homes amid signs that would-be home buyers are trying to time a market bottom before committing to new purchases.

Looking ahead to Wednesday, Action Economics predicted a 5.9% plunge in August housing starts to a 1.30 million unit pace and said it expects the credit crunch to resonate across the construction, sales and sentiment reports in August and September.

The weak nonfarm payrolls report two weeks ago is what ultimately convinced the central bank it needed to acknowledge the chance of a very bad outcome for the economy, but a rate cut amid the run-up in commodity prices and crude oil above $80 jeopardizes its inflation-fighting credibility, Action Economics said.

The question of a possible recession didn't evaporate with the rate cut, although Kurt Karl, Swiss Re's chief market economist, said in a prepared statement that the absence of a lot of built-up inventories or excess capital equipment would likely make any recession short and shallow. Credit markets, however, will continue to experience heightened volatility, he predicted.

David Malpass, chief global economist at Bear Stearns Cos. (BSC) said on CNBC that the biggest impact from the rate cut may be on business investment both in technology and hiring new workers, which would support the economy on the consumption side and help guard against recession.

As if to remind freshly exuberant investors that inflation still poses a threat, crude oil for October delivery in New York settled 94 cents higher at a new record high of $81.51 per barrel, getting an extra 10-cent lift in the last 15 minutes of the trading session from the Fed's apparently front-loaded action to stave off a slowing in economic growth. Oil prices have been pushed higher mostly by general supply concerns, supplemented by speculative fund buying, Action Economics said. A lower Fed funds rate puts pressure on the U.S. dollar, making oil prices cheaper for foreign countries, which is bullish for oil prices, CNBC said.

Among stocks in the news on Tuesday, Lehman Brothers reported better-than-expected earnings of $1.54 a share for the third quarter, vs. $1.57 a year ago, despite a 3.1% rise in revenue rise. The brokerage said it wrote down $700 million worth of loans and mortgages. While it beat analysts' consensus estimate of $1.47 a share, naysayers point to $72 million in tax savings as the only reason for the earnings beat and say the fixed-income business still faces sharply reduced asset values. Standard & Poor's maintained its sell rating. Shares finished 10% higher.

Best Buy Co. (BBY) shares rose 6.6% after the company posted a profit of 55 cents a share for its second quarter, up from 47 cents a share in the prior-year period. The electronics retailer credited a 3.6% increase in stores open at least one year and a 15% jump in total sales.

The company now expects to finish in the upper half of its revised earnings forecast range of $3.00 to $3.15 a share for fiscal 2008.

Adobe Systems (ADBE) shares were up 1.5% after it reported a 55% surge in earnings to 45 cents a share from 29 cents a share in the third quarter of 2006 on a 41% jump in revenue. The software designer projects fourth-quarter revenue of $860 million to $890 million and non-GAAP earnings of 46 to 48 cents a share. S&P raised its profit estimates and kept its buy rating on the stock.

E*Trade Financial Corp. (ETFC) shares fell after it announced it will exit its wholesale mortgage business and restructure its institutional sales trading business. The online broker raised its allowance for loan losses and cuts its 2007 earnings forecast to $1.05 to $1.15 a share from a prior range of $1.53 to $1.67. S&P downgraded the stock to a hold from a buy rating. The rate cut helped the stock bounce from being down over 6% to a 1.5% decline.

Kroger Co. (KR) shares climbed 7.7% after it reported a second-quarter profit of 38 cents a share vs. 29 cents a year ago due to a 5.1% gain in identical supermarket sales and a 6.6% rise in total sales. For fiscal 2008, the supermarket chain sees identical supermarket sales growth of 4% to 5%, excluding fuel, and earnings of $1.64 to $1.67, compared with a prior range of $1.60 to $1.65 s share.

European equity indexes regained their footing as the Bank of England said it would guarantee all of Northern Rock's (NRK.L) deposits to end a run on the mortgage-lending bank. In London, the FTSE 100 index was up 1.63% to 6,283.30. Germany's DAX index climbed 1.27% to 7,575.21. In Paris, the CAC 40 index rose 2.02% to 5,549.35.

In Japan, the Nikkei 225 index fell 2.02% to 15,801.80. In Hong Kong, the Hang Seng index edged down 0.09% to 24,576.85. The Shanghai composite index was up 0.07% to 5,425.21.

Treasury Markets

Yields plunged in the wake of the FOMC's rare and surprisingly deep cut in both the Fed funds target and discount rate by a half percent, reports Action Economics. The 10-year yield sank to 4.46% and bounced to 4.47% on the inflationary implications.

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