The Wall Street Journal-20080128-Hitch Your Wagon to a Rate Cut-- Stocks- Tepid Response Has Investors Inspecting Fed-s Fine-Tuning Skills

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Hitch Your Wagon to a Rate Cut?; Stocks' Tepid Response Has Investors Inspecting Fed's Fine-Tuning Skills

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Some investors are disappointed that U.S. stocks haven't rebounded more decisively after last week's Federal Reserve rate cut, the largest since 1982. These investors have been taught that stocks rise when the Fed cuts rates, especially when it cuts this much. They want to know what is wrong.

Stock indexes remain well below September levels, even though the Fed has cut its target rate four times, to 3.5% from 5.25% since September began. Policy makers are widely expected to cut again after meeting tomorrow and Wednesday.

Last week, stocks fell Tuesday after the Fed sliced the target rate three-quarters of a percentage point. They recovered strongly Wednesday and rose again Thursday, only to fall sharply Friday.

Why aren't stocks reacting more positively? The short answer, according to economists who have studied past Fed moves, is that for all the talk about the Fed, it isn't the only game in town.

For Fed rate cuts to boost stocks, they have to come when stocks are ready to react. Past Fed rate cuts sometimes came later in the cycle, when stocks had fallen longer or harder than this time and were poised to recover. They just needed the Fed's push. In other cases, the underlying problems, which today include troubled credit markets, inconsistent corporate profits and heavily indebted consumers, weren't as grave.

This time, many investors fear that the problems are too big for a quick fix. If that view proves too pessimistic and the economy escapes recession, then investors may look back on last week as the tentative start of a stock recovery. Otherwise, while the Fed cuts will soften the pain, probably shortening any recession and market downturn, they won't serve as a magic wand.

"Other things being equal, you would expect that if interest rates are lower and earnings expectations are higher, that would drive stock prices up," says Ray Fair, an economics professor at Yale University. If investors fear profit declines, however, stocks can fall despite rate cuts, he says: "This time, people may be more pessimistic about earnings due to mortgages and other issues."

Fed Chairman Ben Bernanke, a former Princeton University economics professor, has studied the impact of rate cuts on stocks and arrived at a similar conclusion. Rate cuts help stocks if they are a surprise, he and Oberlin College professor Kenneth Kuttner wrote in a 2003 study, but "monetary policy surprises are responsible for only a small portion of the overall variability of stock prices."

His predecessor, Alan Greenspan, put it this way in a March 2001 Fed policy meeting, according to a transcript: "Flooding a depressed market with excess liquidity, unless that succeeds in revving up a moribund economy, cannot revive a deflated stock market."

Some economists and investors worry that the Fed sent an ominous signal by cutting rates so much last week. The big rate cut persuaded some people that the Fed fears recession is at hand.

"It is a signal of how bad the Fed thinks the future is looking," says economics professor Roberto Rigobon at Massachusetts Institute of Technology's Sloan School of Management. "The rate cut improves things, but the fear of recession is stronger."

A rate cut helps stocks in several ways. By lowering market interest rates, it reduces the return on bonds and money-market accounts, making stocks look better in comparison. It makes it cheaper for consumers and businesses to borrow; this stimulates the economy and can lead to faster growth. If recession is threatened, rate cuts can help prevent or mitigate it. A rate cut also can fuel investor optimism.

The actual economic impact typically doesn't kick in for six to 12 months, however. That means that if a recession is beginning, the rate cuts may lessen its impact, but not prevent it. Heavy rate cuts also can fuel inflation and cause investment bubbles -- and the nagging inflation concern was one reason the Fed was initially reluctant to cut rates this time.

Some analysts think that, whatever happens at first, stocks will be up within a year. Charles Reinhard, director of portfolio strategy at New York fund manager Neuberger Berman, studied the past 11 series of Fed rate cuts. He concluded that in all but the most recent one, 2001, stocks showed gains a year after the Fed started, with an average one- year increase of 16%. He considers 2001 an aberration because it followed a devastating stock bubble.

He notes, however, that stocks at times suffered nasty declines before turning up. In four cases, stocks still were down five months after the rate cuts began.

Whether stocks rise after rate cuts depends on whether the economy is poised to rebound or poised to sink, says Chris Johnson, chief executive of Johnson Research Group. "Take your cue from what's going on in the economy -- that will trump the Fed every time," he says.

Historical data can be a little misleading, because the Fed changed its approach to rate cuts starting around the mid-1980s. Instead of reacting to economic cycles, the Fed began trying to act pre- emptively, trying to cut rates in advance of actual recession. That didn't prevent recession or a stock bear market in 1990 or 2001, but it did work in 1995 and again in 1998 (when the problem was a series of financial shocks, rather than a recession risk).

This time, because the Fed felt inflationary pressures were under control, it decided to move in September, at a time when the economy still was growing strongly. That meant that, instead of cutting rates as the economy came out of recession and was poised to rebound, the Fed was fighting to hold back the forces of frozen credit markets.

A lot of people now are second-guessing the Fed.

Some say it moved too slowly. Prof. Rigobon says the Fed should have cut more at its October and December meetings. It cut by half a percentage point in September, but by only a quarter point at the next two meetings. If it had cut by half a point at each meeting, it wouldn't have felt as tempted to take the mammoth cut last week, he says.

Others say it moved too soon.

"The Fed never moves this early," says Diane Garnick, investment strategist at money manager Invesco Ltd. "Think of where we are in the business cycle. We have had one quarter of disappointing growth. It really worries me because if we need some incremental stimulus in nine months, we lose that opportunity."

Prof. Fair says the Fed should be focusing on the economy, not stock prices. "It is strange to think that the Fed is being driven in its decisions by the market," he says, adding that based on Mr. Bernanke's academic work, he would have expected the Fed chairman to focus on inflation levels. "This behavior is not consistent with his academic work," Prof. Fair says, adding that it also is sending the wrong signal to investors, encouraging them to take excessive risks.

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Mark Gongloff and Anita Raghavan contributed to this article.