Stock Watchers Are Cautious After Fed Cut

The market usually soars when the central bank changes course--but maybe not this time.

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The stock market soared immediately Tuesday with the Federal Reserve's surprising decision to cut interest rates by a greater-than-expected half a percentage point, and if history is a guide, the boost could continue in the weeks and months ahead. But after the euphoria passes, investors will have plenty of reason to be cautious as they try to capitalize on the likely trend.

After all, the economy must still grapple with the issues that led to the Fed's abrupt reversal in course since its last meeting just six weeks ago. The large rate cut confirms the central bankers' view that the economy is weak. "We're no longer fighting inflation," says Alan Skrainka, chief market strategist at Edward Jones. "We're fighting a slowing economy." But his advice to investors is not altered by the rate cut: Seek quality and diversification, and maintain a long-term outlook.

The cut in the federal funds rate from 5.25 percent to 4.75 percent is a move that will immediately be reflected in the bank's prime lending rate, the benchmark for millions of consumer and business loans. At the same time, the Fed lowered the discount rate, the rate it charges commercial banks for short-term loans, by half a point to 5.25 percent. That comes on top of another half-point reduction in the discount rate that the Fed announced on August 17. The discount rate is viewed as symbolic of the Fed's direction in monetary policy. Over the past 60 years, the first Fed discount rate cut in a series has led to higher stock prices after three months in 11 of 14 easing cycles, or 78 percent of the time.

But some market strategists wonder if this may be one of the exceptions to the rule. "The difficulty lies in the wild card, and that is the downturn in the housing cycle," says James Stack, editor of InvesTech Market Letter. "With the inventory of existing homes doubling over the last three years and continuing to hit record levels, we clearly have not seen the bottom in the housing bust. So there is this question of whether or not a rate cut will be as effective this time."

Stack also notes that in most cases, a first Fed rate cut has come after a bear market and a recession. Not so this time. In fact, despite the investor scares of recent weeks, this is still the second-longest period in Wall Street history without a 10 percent correction in the S&P 500. (The only longer period was during the 1990s.)

As a result of housing uncertainties and the aging bull market, Stack says InvesTech has moved to its most defensive position in five years, with an equivalent cash position of 50 percent. "It's better to err on the side of caution than to be swinging for home runs right now," he says.

For investors, it's especially difficult to figure out where exactly to put their money. Technology stocks, with a 21 percent gain over six months, and consumer discretionary stocks, with an 18 percent increase, have historically been the best performers after a Fed rate cut. But some analysts say signs of retrenchment make it unclear that the usual increase in tech spending will follow this cut. Consumer spending is also an uncertainty, because of the generally high level of debt, the housing downturn, and the fact that payments on adjustable rate mortgages may be sucking up some discretionary income.

But Sam Stovall, chief investment strategist for Standard & Poor's, points out that even though there are uncertainties about the economy in the short term, there is a very good chance that a year from now, the market will be up. In fact, 12 months after a first rate cut, the market has always risen (except in 2001, when Wall Street was grappling with the fallout from the Internet stock bubble and the 9/11 terrorist attacks).

The average increase in the market a year after a Fed rate cut is 18.8 percent. "Basically, you get two years' worth of [average] returns in one year," says Stovall. "So although you might want to take a little bit of a cautious approach in these coming months, longer term, you do want to be very cognizant of the old phrase, 'Don't fight the Fed.'"