Stocks: When the Rate Music Stops

Should investors panic if the Fed halts its rate cuts? Maybe not, says S&P. History points to continued stock gains after past easing cycles

We all know that investors are anticipators. So it should come as no surprise that the Standard & Poor's 500-stock index advanced an average 19% during the 12 times since World War II after the Federal Reserve Board started a rate-cutting program. Indeed, the S&P 500 was higher 12 months after the first rate cut in 11 of the 12 observations, with 2001 being the only time in which the equity market benchmark was not higher a year after the initial cut.

This time around, even though the S&P is down 6.2% through May 16 since the Fed started its rate-cutting program on Sept. 18, 2007, the market was also still in negative territory six months after the first cut in four of the prior 12 observations, so we still have a chance for the "500" to advance in the next four-and-a-half months.

Enough Momentum?

Equity investors now have something else to consider: Standard & Poor's, as well as many other analysts on Wall Street, believe Ben Bernanke & Co. likely cut the Fed funds rate for the last time for this rate-easing cycle at its April policy meeting. We think the Fed will now sit back and watch three things: First, they'll see if the prior rate cuts have begun to bolster the economy, as it typically takes rate cuts six to 12 months to work their way into the system. Second, the Fed will watch if the tax rebate program will begin to jump-start a sluggish economy.

Finally, the Fed will wait and see if the rate reductions and rebate checks will lead to an acceleration of inflation indicators, which could force the Fed to begin raising rates sooner than the average 13 months after the last rate reduction.

If the Federal Reserve has stopped cutting the Fed funds rate, and thereby halted the delivery of additional fuel to ignite a sputtering economy, should investors panic? Not according to history. Even though what worked in the past may not work in the future, in the 12 times since World War II that the Fed has ended its rate-easing efforts, the building momentum of economic stimulation offered by a succession of interest rate reductions has traditionally had the momentum to power investors' expectations for economic expansion, and has given them courage to add to equity positions.

Small Caps Are the Winner

Indeed, since 1945, in the six- and 12-month periods after the last interest rate cut, the S&P 500 gained an average 9.4% and 18.9%, respectively (excluding dividends). What's more, the market advanced in 11 of 12 observations during both six- and 12-month periods. Six-month gains ranged from 0.6% in 1996 to 23.6% in 1982, while 12-month advances ranged from 6.3% in 1980 to 35.9% in 1954. Only in 1976 did the S&P 500 decline, posting a 3.1% tumble in the six-month period and a 6.3% fall in the 12-month time frame.

In addition to U.S. equities doing well overall after the final rate cut, investors gravitated toward the growth side of the equation, as the S&P 500 Growth index posted a 10.2% average increase six months after the last rate cut vs. the S&P 500 Value Index's 8.6% advance. The story was similar 12 months out as growth beat value 17.4% to 15.4%. Growth also beat value in six of eight observations after six months, but was tied 4-4 after 12 months. Just as with the broader market, only during the 1976-77 period did these indices not rise after the final cut.

Small-cap issues, as measured by the Russell 2000 Index, rose an average of nearly 15% six months after the final rate cut and more than 25% after 12 months, posting increases in all observations.

Looking at performances since 1980, the earliest observation common to all indices, we see that while stocks in general have done well after the last rate cut, growth issues have beaten value stocks, and small caps have outpaced them all.

Sector Standouts

Encouraged by the market's performances after the last rate cut, and digging a little deeper to see how sectors performed after the last cut, we see that the strongest price performances came from the cyclical Consumer Discretionary, Industrials, and Information Technology sectors in both the six- and 12-month periods, as they posted above-average price advances and frequencies of market outperformance.

The traditionally defensive sectors—Consumer Staples, Health Care, and Utilities—which normally held up well during rough patches in the market's performance, were underperformers in both periods, possibly as a result of investors' continued interest in the more cyclical sectors. Interestingly, Energy and Materials, today's sector leaders, historically maintained their leadership positions in the first six months after the Fed stopped cutting rates, but then slowed to become market performers during the 12-month period.

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

S&P's Equity Strategy Group has been raising the recommended exposure to cyclical sectors and reducing the suggested allocations to defensive ones. Since the beginning of the year, we elevated our investment outlooks on the Consumer Discretionary, Financials, Industrials, and Information Technology sectors, while downgrading our opinions on Consumer Staples, Health Care, and Utilities.

We currently have overweight recommendations on the Information Technology and Materials sectors, and recommend an underweighting on the Health Care and Utilities groups.

Industry Momentum List Update

Here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).

Subindustry Company Ticker S&P STARS Rank Price (5/16/08)
Coal & Consumable Fuels Peabody Energy BTU 3 $79
Construction & Engineering Fluor Corp. FLR 4 $191
Diversified Metals & Mining Freeport-McMoRan Copper FCX 3 $124
Fertilizers & Agr. Chem. Monsanto MON 4 $125
Gold Newmont Mining NEM 4 $49
HyperMarkets & Super Centers Costco Wholesale COST 4 $73
Industrial Gases Airgas ARG 5 $60
Integrated Oil & Gas ConocoPhillips COP 5 $92
Marine Kirby Corp. KEX 4 $60
Oil & Gas Drilling Noble Corp. NE 5 $65
Oil & Gas Equip. & Svcs. Superior Energy Services SPN 5 $54
Oil & Gas E&P Swift Energy SFY 5 $60
Railroads CSX Corp. CSX 4 $66
Steel Allegheny Technologies ATI 4 $82

Source: Standard & Poor's Equity Research

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