THE EFFECT OF FEDERAL RATE CUTS ON THE STOCK MARKET

The country was recently treated to the sixth successive rate cut by the Federal Reserve. How did the stock market respond? Investors collectively held their breath and let out a big yawn. The Fed Funds rate was cut 25 basis points (that is, one-fourth of one percent) on June 27. Five larger cuts earlier this year, each measuring 50 basis points, preceded the 25 basis points cut. The Standard & Poor’s 500 Stock Index (S&P 500) closed down five points at 1211.07 the day of the announcement. While it closed 15 points higher the next day, it nosedived two weeks later. On July 11, the S&P 500 closed at 1180.18.

The Fed Funds rate, which began January 3 at 6.5 percent, has been whittled to 3.75 percent, the steepest decline in Alan Greenspan’s tenure as Fed Chairman. After the early January decrease, the Fed followed suit on January 31, March 20, April 18, and May 15, hoping that as the money supply loosened, the faltering economy would get back on its feet. The fact that we’ve now witnessed our sixth rate cut in less than six months indicates that the economy still needs healing.

The inability of the latest rate decrease to substantially affect stock prices should come as little surprise. Using the S&P 500 as a gauge, history shows us that since 1929, Fed rate cuts are effective at the outset, but diminish in their ability to continue a positive trend in stock prices when coming on the heels of previous rate cuts. In that 72-year period, 18 initial rate cuts produced an average gain of 4.47 percent three weeks later. In 16 cases, a second rate cut followed, producing an average gain of 3.41 percent three weeks later. When a third rate cut occurred without an intervening increase, the average gain came to 3.72 percent. But subsequent consecutive rate cuts show a pronounced drop in their ability to positively affect the market.

This wisdom holds true over periods extending beyond three weeks. The chart below shows how the S&P 500 has fared after as many as six successive rate cuts during periods that extend to one year after the most recent cut (please note that the days indicated are days on which the stock market was open, excluding weekends and holidays; thus, 252 market days amount to one calendar year).

S&P 500 Performance after Federal Reserve Interest Rate Cuts

Once we progress past a third rate cut, a trend toward diminishing returns is evident. Conversely, investors may take heart from the market’s ability to strongly rebound within a year after the rate cutting subsided, especially in the seven instances where a sixth rate cut occurred.

In the current cycle of rate cuts, only the decrease announced on April 18 had any short-term staying power. The S&P 500 closed at 1238.16 on April 18 and closed at 1267.43 ten market days later. In four other instances, the index was down ten days later; the other time, the index was up less than one percent.

The S&P 500 primarily encompasses the large-cap universe. When we take a look at the experience of the mid-cap and small-cap sectors (represented, respectively, by the S&P MidCap Index, established Jan. 2, 1981, and the Russell 2000 Index, established Jan. 2, 1979), different trends are revealed.

S&P MidCap Index Performance after Federal Reserve Interest Rate Cuts

Russell 2000 Index Performance after Federal Reserve Interest Rate Cuts

Where both indexes are concerned, the fourth and fifth rate cuts led to the strongest gains. In the four instances where the Fed cut rates a sixth time, the one-month period following the cut showed a negligible return among mid-caps and a negative return among small-caps. Time proved a tonic, however. Returns for six months thereafter and beyond were more in line with the scenarios that resulted when the Fed stopped after four and five rate cuts.

Contemplation of this issue and the numbers used to support the conclusions arrived at above shouldn’t be viewed as predictive of future market movements. Past performance can never be used as a guarantee of future events. Rather, you might consider how the market has responded to events in the past as one component in devising your own strategy for making the market work for you.

With the Fed Funds rate now shaved to about as low a figure as it will go, the Fed’s ability to impact the stock market is largely curtailed. Other factors will loom larger in determining the bullishness or bearishness of investors.

The strong U.S. dollar has proved a hindrance to the ability of domestic producers to compete overseas. Many foreigners lack the purchasing power to avail themselves of goods exported from this country. Furthermore, the desperate plight of foreign economies has led foreign investors to accumulate U.S. dollars as a hedge against the weakening of their own currencies, which only exacerbates the problems they face in their homelands.

The domestic economy has been held together by consumer spending, but creeping unemployment and burgeoning personal debt levels could frighten consumers, stifling personal spending. Corporate earnings, which have lately proved disappointing to investors, could be negatively impacted, sending stock prices on another downward spiral.

All Mr. Greenspan and Co. can do now is that which everyone else has been doing for some time now – sit back, watch, and wait to see what happens.

Ned Davis Research, Atlanta, GA, provided all data used in this article.

The above article is for general information only and is not intended to provide specific advice or recommendations for any individual. Consult your attorney, accountant, or financial or tax advisor with regard to your individual situation.

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