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Monday Morning: If long rates also ease, stocks should rise

What’s the market going to do now that the Fed has cut interest rates another half percent? Last…

What’s the market going to do now that the Fed has cut interest rates another half percent?

Last Tuesday, immediately after the cut, the market was not impressed. On Wednesday, the market suddenly decided it was impressed after all.

Theoretically, if long rates follow short rates down, the present value of future corporate earnings has just increased, meaning the values of companies, and hence stock prices, should rise. Why? Future earnings are being discounted back to a present value at a lower discount rate, making them more valuable.

In fact, according to research by Bruce Steinberg, chief economist at Merrill Lynch, the equity market has always rallied after a 30% cut in the fed funds rate, and that 30% level was reached before the latest cut.

According to Mr. Steinberg’s research, during the past 50 years, there have been 10 previous easing cycles in which the Federal Reserve has cut rates by at least 30%, and the equity market was up a year later in every case. The average gain was 25%, though in 1967 it was only 4%, and in 1981 only 10.7%.

If Mr. Steinberg’s research holds true, investors should have healthy gains on their equity portfolios a year from now.

However, there is a complicating factor. This is the inaugural year for a presidential administration. And according to research by Tom McManus, equity portfolio strategist at Bank of America Securities in New York, inaugural years have not been very good years for the market.

In fact, according to his research, the first year of a Republican administration with a Republican Congress has usually been a down year for the market, and a Republican administration with a Democratic congress hasn’t been much better.

“I don’t make a big deal of this, but history shows [Republican president, Republican Congress] is not a great combination,” says Mr. McManus. And he would be a little bit cautious in the third quarter, during which the market historically has performed poorly in Republican/Republican inaugural years.

So, on the basis of history, 2001 could be a fairly weak year for the market. But there has been only one inaugural year in the past 50 years during which the Fed eased by 30% or more. That was 1981, and that year the market gained 10.7%.

Interestingly, that year the Reagan administration, like the current administration, was seeking a substantial income tax cut.

There is another complicating factor. The Fed can cut short-term rates, but long-term rates don’t have to follow them down, and won’t if the bond market fears a return of inflation.

If long-term rates don’t drop, then the discounted present value of the future corporate earnings won’t rise, and hence stock prices won’t rise – unless multiples increase again, which is unlikely since they’re still at relatively high levels.

What’s the bottom line? Despite the Fed cut, the odds are that 2001 will be a mediocre year for stocks. The key will be what happens to corporate profits and long-term rates.

The Fed rate cuts before last Tuesday’s didn’t lift the market out of its doldrums, because earnings were falling fast enough to offset the effect of the rate cuts on the present value of earnings streams.

So watch earnings reports. If the bad news begins to level off, then the interest rate cut might indeed provide a long-term lift to equity prices. If the bad earnings reports continue to accelerate, watch out.

If long-term rates don’t follow the short rates down, the market won’t pick up significantly until earnings turn up. And if long-term rates begin to rise, watch out also.

Mike Clowes is the editorial director of InvestmentNews.