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

by David Bogoslaw

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."