Rate Cut Jump-Starts Market’s New Year

The stock market may have a happy new year after all.

The Federal Reserve’s surprise interest rate cut Wednesday sparked a wild rally as Wall Street bet that falling interest rates once again will prove to be the market’s best friend.

Historically, that has almost always been the case: Stocks tend to gain when the Fed trims rates--barring an unexpected global shock.

Investors clearly trusted history: The beaten-down Nasdaq composite index soared 324.83 points, or 14.2%, to 2,616.69, a record one-day percentage gain. Nasdaq trading volume totaled 3.12 billion shares, topping the previous record of 2.88 billion shares set April 4.

The blue-chip Dow Jones industrial average rose 299.60 points, or 2.8%, to 10,945.75, and the Standard & Poor’s 500-stock index surged 5%.

Last year’s broad market decline, which saw Nasdaq fall a record 39.3% and the S&P; 500 fall 10.1%, was in large part a reaction to the weakening economy and slowing corporate earnings growth.

Now, the hope is that lower interest rates will translate into a stronger economy and rising corporate profits by midyear.

Some analysts predicted Wednesday that major market indexes are certain to see double-digit gains this year, thanks to the Fed.

“Stocks will be higher a year from now than they are today,” said Charles Pradilla, chief investment strategist at New York-based investment firm SG Cowen.

But the ride could be anything but smooth, many pros warn. The first quarter in particular is likely to be bumpy for the market, many say.

Rate cuts usually take six months or longer to filter through the economy and show up on corporate bottom lines. That means the first half of the year is likely to be dotted with the sort of disappointing profit and economic reports that yanked the market--especially the tech sector--down throughout the fourth quarter.

The continued drumbeat of such bad news could weigh on stocks and raise the question of whether the Fed acted too late to avert a recession, experts note.

Indeed, the market staged a number of breathless one-day advances throughout 2000. Each one sparked predictions that stocks were about to right themselves. But the market continually faltered under the weight of repeated bad news.

“The tech stocks that are at the core of the [Nasdaq] are going to experience a series of negative earnings announcements, which will go on for three quarters,” predicted Peter Anderson, chief investment officer at American Express Financial Advisors. “While we’ve seen the bottom, we’re not going back to the races.”

But to Wall Street bulls, that misses the point. The market certainly won’t move up in a straight line, they say. But the likelihood of higher share prices as the year progresses has been sharply boosted because the Fed will scuttle the negative sentiment that has dominated the market, bulls say.

Now, investor sentiment should shift to the belief that the economy will pick up in the second half of 2001.

The optimism on Wall Street is grounded in the notion that the Fed’s rate cut--as well as the strong hint of additional rate cuts--will prevent a recession from taking hold. Though profit growth will weaken in the near term, the economy will still achieve its much-hoped-for “soft landing,” many analysts say.

“The risk of a recession is significantly lessened,” Pradilla said.

In any case, investors typically have one reaction to Fed rate cuts: They buy stocks.

Richard Cripps, chief market strategist at Legg Mason Wood Walker in Baltimore, said falling interest rates have historically been the single most bullish factor for stocks, particularly when rate cuts occur after a sharp market drop.

Since 1965, the Standard & Poor’s 500-stock index has fallen in eight calendar years, Cripps said. On average, the market has risen 12% the next year. And in the six years when the Fed was cutting rates, the average gain was 18%, he said.

Research by Jeffrey Applegate, chief investment strategist at Lehman Bros., suggests that stocks could be in for even bigger gains.

He studied seven periods since 1962 in which stocks fell sharply because of slowing growth, though a recession didn’t develop.

In those periods, the S&P; 500 was up an average of 31% one year later, Applegate said.

Bulls say the market has several other things going its way.

Though stock price-to-earnings ratios remain high by historical standards--the average blue-chip stock is priced at about 24 times estimated 2000 earnings per share--P/Es are well below last year’s peaks, especially for the most richly valued tech stocks.

What’s more, falling interest rates and low inflation usually make higher P/Es less worrisome to investors. Indeed, investors often have been willing to bid up stock valuations when the economy is stable and inflation is in check, experts note. Assuming no recession, the market is “significantly undervalued” at current prices, Applegate said.

Another plus: Stuart Freeman, strategist at A.G. Edwards & Sons, noted that if yields on money market accounts, bonds and other fixed-income securities fall as the Fed lowers rates, those investments become less attractive as alternatives to stocks.

But many Wall Street pros concede that the market still faces significant risks. If the Fed is too late and recession is inevitable, many stocks are likely to fall much further as corporate profits plunge.

In its weakened condition today, the economy could be especially vulnerable to some sort of outside shock, experts say. Even though the Fed was cutting rates throughout 1989 and 1990, the economy still sank into recession after Iraq invaded Kuwait, triggering a sharp market decline.

Though he thinks the overall economy will avoid a downturn, Anderson believes that certain sectors already are in recession. For example, manufacturing, retail and certain areas of technology such as telecommunication equipment are sputtering, he said.

In fact, the Fed rate cut came on the heels of a report Tuesday showing that manufacturing activity had slumped to its lowest point in almost a decade.

The Fed “could be so far behind the curve that we go into recession,” Anderson said. But “if we can get through the first quarter in one piece, we’ll be much better off. This is the toughest quarter.”

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A Fed Surprise Sends Stocks Soaring

Wall Street’s mood shifted from gloom to panic buying Wednesday after the Federal Reserve surprised the nation with a half-point interest rate cut early in the afternoon.

1:15 p.m. EST: Fed announces half-point rate cut

Wed. close: 10,945.75, up 299.60

Dow Jones industrial average, prices at 30-minute intervals Wednesday

Nasdaq Posts a Record Gain . . .

The 10 largest one-day percentage gains in the Nasdaq composite index:

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Point Percentage Date Close gain gain Jan. 3, 2001 2,616.69 324.83 14.17% Dec. 5, 2000 2,889.80 274.05 10.48 May 30, 2000 3,459.48 254.37 7.94 Oct. 13, 2000 3,316.77 242.09 7.87 Oct. 19, 2000 3,418.60 247.04 7.79 Dec. 22, 2000 2,517.02 176.90 7.56 Oct. 21, 1987 351.86 24.07 7.34 April 18, 2000 3,793.57 254.41 7.19 April 25, 2000 3,711.23 228.75 6.57 April 17, 2000 3,539.16 217.87 6.56

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. . . as Tech and Financial Stocks Lead the Way

Biggest gainers Wednesday among stock industry sectors in the Standard & Poor’s 500 index:

Source: Bloomberg News