Signs of a Stabilizing Market

With the Sept. 4 rally and the Fed expected to lower the Fed funds rate, the stock market at least could see a significant boost

by Steve Rosenbush

Bankers and traders consoled themselves during the brutal credit crunch this summer with the argument that market conditions ought to improve after Labor Day, as financial professionals returned from pervasive vacations that slow the pace of business.

The markets cooperated on Sept. 4 with a broad-based back-to-work rally. The Dow rose 91.12 points, or 0.68%, to 13,448.86. The S&P 500 rose 15.43 points, or 1.05%, to 1,489.42. The Nasdaq gained 33.88 points, or 1.30%, to 2,630.24 (see BusinessWeek.com, 9/4/07, "Stocks Finish Solidly Higher").

Optimistic Experts

One trading session is hardly enough evidence to confirm the optimistic view that market stability has returned. But viewed as one of several data points, it helps bolster the case that markets are stabilizing, at least when it comes to equities.

A range of market experts believes there is reasonable cause for optimism after a summer that shook investor confidence and rattled the nerves of bankers and traders (see BusinessWeek.com, 8/20/7, "The M&A Deals Most at Risk").

Josef Ackermann, chief executive of Deutsche Bank (DB), said on Sept. 4 markets are stabilizing and he is "optimistic about the environment globally." Ackermann said he took comfort from the actions of central bankers around the world, who stepped in to provide liquidity to frozen markets.

Discount Rate's Historical Signal

In the U.S., for example, the Federal Reserve lowered its discount rate on Aug. 17 and allowed banks to put up as collateral all sorts of things private investors wouldn't touch. That included everything from low-rated debt to boat loans, according to economist and market strategist Edward Yardeni, of Yardeni Research. Yardeni is convinced the Fed will act again on Sept. 18 by lowering the Fed funds rate, giving the stock market a powerful and sustainable boost. "The Fed will bail us out. Does anyone really have a problem with that?" he said in a research note, also on Sept. 4. "The stock market always moves higher once investors become convinced that the Fed's rate cuts have stopped the panic and averted a recession," he said.

Given signs pointing toward an economic slowdown, Yardeni expects the Fed to lower the Fed funds rate by 50 basis points, a sizable reduction. (The discount rate is what the Fed charges banks for short-term loans from the Fed, while the Fed funds rate is what banks charge one another.)

If history is any guide, last month's reduction in the discount rate may be enough to signal a move higher in stock prices. That's the conclusion of a new research report from the CFA Institute, a nonprofit group of chartered financial analysts. The Fed has changed the direction of the discount rate only 15 times during the last 33 years, and stock prices have mounted a sustained rally every time the Fed reduced them, according to Robert Johnson, PhD. Johnson, a managing director with the CFA Institute and co-author of the report, said market returns from 1973 to 2005 averaged 12% a year. The study found the market gained only 5% when the discount rate was rising. The gains were even more pronounced when it comes to cyclical stocks such as financial and information technology companies, which rose 20.3% during periods when the discount rate was on the decline.