Wall Street ready for pause in Fed rate cuts

By Adam Shell, USA TODAY
NEW YORK — A pause in interest rate cuts by the nation's central bank could prove to be refreshing for the stock market.
Investors who once clamored for rate cuts to stabilize a slowing economy and financial system on the verge of a meltdown now are calling for a halt to the Federal Reserve's easing cycle. Wall Street is now of the mind that further cuts would do more harm than good.

The 3.25 percentage-point reduction in the fed funds rate to 2% since September has restored a sense of calm to markets.

But the cheap money has also eroded the value of the U.S. dollar and contributed to an alarming rise in the price of gasoline and food, putting pressure on cash-strapped consumers.

In a statement last week, the Fed hinted that its campaign to lower borrowing costs may be near an end, saying the "uncertainty about the inflation outlook remains high." But it's not just the hope that the Fed can control inflation that has Wall Street wanting an end to the rate-cutting program.

There is a financial motive, as well: Stocks have historically performed very well during "pause periods," when the Fed has stopped lowering interest rates, an analysis by Bespoke Investment Group found.

In the past 50 years, the benchmark Standard & Poor's 500-stock index has rallied 12.3%, on average, in the period from the last rate cut in an easing cycle to the first rate increase. (The S&P is up 2% since the Fed cut on Wednesday, and a total rise of 12.3% would put it just shy of a new high.) The average duration of the Fed's pause in those 12 interest rate cycles in that period was 329 days, or almost 11 months.

Stocks rise when the Fed starts to wean the market off cheap money, because the pause:

•Signals the outlook is brightening. If the Fed no longer sees the need to provide monetary stimulus, it suggests that it is confident the economy is on the comeback trail, says Paul Hickey, Bespoke's chief investment guru.

•Shows lag effect is kicking in. It usually takes six months to a year for the benefits of rate cuts to cycle their way through the economy. Hickey says that when the Fed pauses, it often coincides with signs that the cuts are working.

While those explanations have proved true in the past, circumstances surrounding the Fed's hoped-for pause now may suggest a different outcome for stocks, says Christopher Orndorff, managing principal at money management firm Payden & Rygel.

"Historically, stocks go up because the market assumes the Fed has done their job," says Orndorff. This time, a pause is expected, "not because things are rosy again in the economy, but because inflation is higher than they would like."

Orndorff says the Fed would be in a tough spot if the economy weakens more, because if it is forced to cut again, it could fan inflation. The Fed meets again on interest rates at the end of June.

Bear of different kind mauls 1st quarter

By Adam Shell, USA TODAY
NEW YORK — Undone by the fallout from the real estate bust, Wall Street resembled a house of pain in the first three months of 2008.
When the first quarter ends Monday, it will take its rightful place among the stock market's most treacherous periods. It will forever be linked to the collapse of investment bank Bear Stearns (BSC) after a 1930s-style run on the bank and the Federal Reserve's dramatic move to rescue the financial system.

The key debate now is whether the worst is over, whether stocks reflect all the bad news, or whether the downward trend is still in force.

The 9.7% first-quarter loss posted by the Standard & Poor's 500 index through Thursday is puny compared with the biggest quarterly drop ever: 39.4% in the second quarter of 1932, S&P says. If the decline holds, it would barely make it into the top 40.

But while the loss might not be of historical proportions, it still underscores how vulnerable the financial system is to the toxic combination of rampant speculation and leverage. It also is a clear reminder of how quickly financial markets can unravel if all-important investor confidence takes a major hit.

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Stock declines of this magnitude in a quarterly span are relatively rare — often coming during the doom-and-gloom of bear markets or shock-induced scares. Indeed, the credit-crunch-inspired plunge in the first quarter ranks right up with the market angst caused by America's most famous financial crises:

•The 10.3% drop in the third quarter of 1998 when hedge fund Long-Term Capital Management collapsed.

•The 14.5% decline in the third quarter of 1990 in the aftermath of the savings-and-loan crisis.

•The 23.2% plunge in the fourth quarter of 1987 after the October market crash.

Four of the five biggest quarterly losses came in the years after the 1929 stock market crash. The fourth worst came in the third quarter of 1974, at the tail end of the 1973-74 bear market.

The big question now: What happens next? Patrick Adams, a hedge fund manager at Choice Investment Management, sees gains ahead. "The second quarter is not likely to look like the first quarter," he says. The Fed's aggressive move to support ailing Wall Street banks and the hard-hit mortgage market has reduced the odds that another major negative bombshell is out there.

Adams says investors should buy stocks on price drops. He expects stocks to react negatively at first to weak first-quarter profit reports but to rebound quickly. "We are close to a trough, and once the market is confident (a bottom is in), we could have a pretty big rally," he says.

But with the economy slowing, joblessness on the rise and the real estate market reeling, caution might seem a more prudent choice. "Bulls will say the current slowdown is a mere flesh wound, while bears may use it as a road map for what is likely to come. We're somewhere in the middle," Jason Trennert of Strategas Research Partners wrote to clients recently.

Stocks' first quarter was a real downer

By Matt Krantz, USA TODAY
Investors looking back at the first quarter that ended Monday won't have any trouble locating the lowlights. It's the highlights that are harder to find.
Hammered by the failure of Bear Stearns, oil skyrocketing to more than $110 a barrel, historic weakening of the U.S. dollar and rising inflation, the market by most accounts had a terrible first three months of 2008. The Standard & Poor's 500 fell 9.9%, marking its worst quarter in 5½ years. It has fallen five consecutive months for the first time since 1990, says S&P.

"We ended up with a steady diet of bad news," says Noel Lamb, chief investment officer at Russell Investments. "Any highlights were overcome."

Still, as few highlights as there were, they provided some potentially encouraging signs, including:

•Recent dogs perked up Some industries beat up the most badly last year were among the biggest gainers in the first quarter. The best example: Home builders' stocks, which lost half their value last year, gained almost 13.8% in the first quarter, just shy of the top spot held by energy exploration and production companies, which gained a little more than 13.8% on record oil prices. "For a quarter dominated by recession fears, there was good performance by some," says Jim Paulsen of Wells Capital Management.

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•Economy plays were strong. Some investors appeared to be betting that any economic malaise will be short. Residential REITs, which invest mostly in apartment buildings, gained 8.0% during the quarter. And in another vote of confidence that the economy will not grind to a long halt, railroad stocks rose 9.6%. If the economy were truly headed toward a prolonged recession, investors wouldn't be jumping into transportation stocks this soon, Paulsen says.

Meanwhile, earnings forecasts for the broad market are hanging in there. Analysts are calling for 6.5% lower earnings in first-quarter results, says Howard Silverblatt of S&P. But strip out financials' results, and earnings are expected to grow 8.5%. Meanwhile, analysts expect earnings to stabilize in the current quarter, rise 19.3% in the third and jump 73% in the fourth.

Still, many say it's too soon to be focusing too hard on the bright spots. The fact investors are clinging to defensive investments such as gold and shares of companies that make consumer necessities shows caution, says Fa'iz Marhami, portfolio strategist at Rydex Investments. Technology stocks were also weak, helping pull the Nasdaq composite down 14.1%. "Investors are moving to what they feel is less risky," he says.

And while stocks in some industries fared well, all 10 broad market sectors fell during the quarter, S&P says. Even the best group, consumer staples, fell 3.0%. "Sure, we can end up with bits of good news to give us grounds for optimism," Lamb says. But he says more bad news is coming and it "is not all priced in."