S&P cautions investors against assuming the Fed's rate-cutting signals an "all-clear" to the subprime crisis
From Standard & Poor's Equity ResearchOn Friday, Aug. 17, the Federal Reserve cut its discount rate 0.50%, to 5.75%. The equity markets responded favorably to the Fed's action, as it sent a message to investors that the central bank will do whatever it can to alleviate the lending paralysis brought on by the fear surrounding the spread of the subprime worries.
It also reminded investors that one of the strongest share-price propellants is lower interest rates. As a result, investors may have concluded from history that share prices are now on sale and could soon head higher.
Our advice this time around is, as always: Use history as a guide, but not gospel. The rate reduction, in our view, relieved the tension surrounding the credit crisis, but has not removed the underlying concern surrounding the economy and the stock market. But just in case you forgot how markets and sectors have historically performed after rate cuts, here are a few things worth considering.
Consumers love a sale, especially when they get two for the price of one. Investors are the same way. Wall Street tends to get very excited whenever the Federal Reserve begins a new rate-cutting program. The reason is, according to history, when interest rates have started to go on sale, investors typically received two-for-one stock price returns. In other words, investors have received 12 months' worth of stock market advances in only a six-month period.
Take a look at the accompanying Table 1, showing price performances for the major stock and bond indices six months after the Fed started lowering interest rates. (Discount rates were analyzed from 1945 to 1982, with the Fed funds rate used since then.)
The Fed has started rate-cutting programs 10 times since World War II (11 times, if you include Friday's rate reduction.) In the six-month period after the first cut, the Standard & Poor's 500-stock index advanced by an average of 11.0%, two percentage points better than the average 9.0% price increase in all years since 1945. A bit surprisingly, the market did not rise in each observation, as stock prices fell four 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 cases (lower rates were not enough to stop the market meltdown in 2001).
But is the S&P 500 the best place to be once rates start tumbling? Since 1980—the consistent starting period for the S&P 500, its growth and value components, the Nasdaq, small-cap benchmarks, and bond proxy—we see that during the first six months of rate reductions, growth generally beat value, small caps outperformed large caps, and the cyclical groups (as determined by the proxy for the group, the Nasdaq) beat them all.
Finally, we see that while bonds advanced fairly consistently, they usually lagged equities even as rates fell.
Digging a Little Deeper
Since 1945, there were 10 observations of rate-cut initiations. The S&P 500 declined in four of the 10 interest rate observations, and posted strong annualized results on average. Growth stocks tended to outperform value stocks by an average of more than 400 basis points and did so more than two-thirds of the time.
We also find that the strongest price performances came from the cyclical Consumer Discretionary, Industrials, and Information Technology sectors, while the Telecom Services and Utilities sectors posted the smallest average advances (see accompanying Table 2).
Remember, of course, that past performance is no guarantee of future results.
S&P's Investment Policy Committee recommends investors take a cautious approach to the market in the coming weeks, and advises against assuming that the Fed's rate cut signals an "all clear" to the concerns surrounding the housing and subprime turmoil. Our yearend target for the S&P 500 remains at 1510, and S&P's Equity Strategy group continues to recommend an overweighting of the S&P 500 Energy, and Health Care sectors, while underweighting the Consumer Discretionary, Materials, and Utilities sectors.
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 subindustries in the S&P 1500), along with a stock with the highest S&P STARS (tie goes to the highest market value).
S&P STARS Rank
Auto Parts & Equipment
Johnson Controls (JCI)
Lyondell Chemical (LYO)
Construction & Engineering
Jacobs Engineering (JEC)
Construction & Farm Machinery
Trinity Industries (TRN)
Vulcan Materials (VMC)
Harman Intl. (HAR)
Diversified Metals & Mining
Freeport-McMoRan Copper (FCX)
Fertilizers & Agr. Chem.
Ingram Micro (IM)
Tires & Rubber
Goodyear Tire (GT)
Source: Standard & Poor's Equity Research