Profiting From Lower Rates

The Fed cuts, and Wall Street celebrates. How to join the party

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Stock traders watch news of the Fed rate cut.

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By Marianne Lavelle and Emily Brandon

Elated investors reacted as if a squadron of choppers hovered over Wall Street dropping cash. So it wasn't with derision, but with appreciation, that stock watchers appraised the judgment of "Helicopter Ben"—Federal Reserve Chairman Ben Bernanke, who faced down his first crisis with a surprisingly aggressive move to guard against the economy's falling into recession.

Bernanke's nickname had haunted him ever since a 2002 speech in which he joked that cash could be dropped from helicopters to help a weak economy if interest rates were at zero. He didn't have to resort to whirlybirds this time but instead delivered double the expected interest rate cut in an effort to contain the turmoil in the housing and credit markets. The Dow Jones industrial average immediately scored its strongest one-day gain in four years. And bullish market strategists like Nick Raich, senior vice president for National City Private Client Group, now expect growth to accelerate through the year's end and into 2008.

"Our call was [that] if the Fed did nothing, inflation fears would have fast turned into deflation, and we would have headed into a recession," says Raich. "If he didn't act, there would have been a big problem, and he's preventing that."

The cut in the federal funds rate from 5.25 percent to 4.75 percent moves the prime lending benchmark for millions of consumer and business loans. And it has implications for homeowners with adjustable-rate mortgages, shoppers with mounting credit card debt, and investors trying to grow their savings. If history is a guide, the boost to the stock market is likely to continue. But after the initial euphoria passes, the economy must still fight off the affliction that compelled the Fed's policymaking committee to take such forceful action.

Euphoria. "The difficulty lies in the wild card, and that is the downturn in the housing cycle," says Jim Stack, president of Stack Financial Management and editor of InvesTech Market Letter. Indeed, housing starts and permits dropped in August to their lowest level since 1995. "We clearly have not seen the bottom in the housing bust," Stack says. "So there is this question of whether or not a rate cut will be as effective this time." As a result of the bloated inventory of unsold homes and the sheer age of the bull market—the second-longest period in Wall Street history without a 10 percent correction in the S&P 500—Stack says he has taken a defensive position: "It's better to err on the side of caution than to be swinging for home runs right now."

Here's how the Fed rate cut may change the money landscape:

Mortgages. Some homeowners facing resets on adjustable-rate mortgages may see a benefit—although most will probably still see sizable payment increases. If you're due for a reset in October, says Greg McBride, a senior financial analyst with Bankrate.com, "instead of jumping to 7 percent, it's going to jump to 6 ¾ percent."

It might be a good time to consider converting to a fixed-rate mortgage. Already, 30-year fixed-rate mortgages had dropped to 6.25 percent, down from 6.42 percent, in anticipation of the Fed cut, the Mortgage Bankers Association says. "You may want to wait a little longer because you'll probably get an even better deal sometime between now and the end of the year," says Mark Zandi, chief economist at Moody's Economy.com. Be sure to carefully weigh the effect of closing costs and fees before refinancing.

Credit card debt. Although credit card rates are heavily influenced by your personal credit history, now is a great time to look for the lowest-rate card and aggressively pay down debt. "Consumers should shop around and look for credit cards where the rate is tied to short-term interest rates and see if they can take advantage of that," says Gus Faucher, director of macroeconomics for Moody's Economy.com.

Savings. The most important impact of the Fed action may be for investors who have socked savings away into money market funds and certificates of deposit. The amount of cash in those safe havens has been increasing substantially. "People decided, 'Why worry about the stock market when you can simply make 5 percent guaranteed?'" says Alan Skrainka, chief market strategist for Edward Jones. "The problem with that is that your principal may be safe, but your income is not," with CD rates now expected to drop quickly. Bankrate's McBride says, "If you've been looking for an opportunity to put money into a long-term CD, now is the time to do it before rates decline."

Stocks and funds. High-quality stocks and mutual funds that throw off dividends have greatly outperformed cash investments over time. Skrainka's advice to investors is not altered by the rate cut: Seek quality and diversification, and maintain a long-term outlook.

Stock prices have usually risen in the six months after the first Fed rate cut in a series. Technology and consumer discretionary stocks have been the best performers in these periods. Yet some analysts urge caution, saying that neither tech nor consumer spending may soar this time if the Fed cut is too little, too late to prevent a major economic slowdown.

But Sam Stovall, chief investment strategist for Standard & Poor's, says there's a very good chance that a year from now, the market will be up. In fact, 12 months after an initial rate cut, stocks always have risen since 1945 (except in 2001, when Wall Street was grappling with the fallout from the Internet stock bubble and the 9/11 terrorist attacks), with a robust 18.8 percent average increase. "So although you might want to take a little bit of a cautious approach in these coming months," says Stovall, "longer term, you do want to be very cognizant of the old phrase, 'Don't fight the Fed.'" After all, they've got the helicopters.

Sectors to watch

Stocks have historically posted strong gains in the six months after the first in a series of Fed rate cuts. Some analysts say this time could be different.

S&P 500 sector Avg. gain over 6 months
Technology 21%
Consumer discretionary 18%
Industries 17%
Consumer staples 14%
Energy 12%
Healthcare 11%
Materials 11%
Financials 10%
Utilities 7%
Telecommunications 4%

Source: Standard & Poor's (data since 1945)