Is Fed Rate Cut Enough to Revive the Market?

NEW YORK â€”  “Don’t fight the Fed,â€� is one of the hoariest bits of stock market wisdom, and with good reason.

Since 1980, never has a new round of interest rate cuts by the Federal Reserve Board failed to result in a higher stock market within a year, as measured by the Standard & Poor’s 500-stock index.

Yet some analysts worry that this time is different.

“You don’t make money betting against the Fed very often, but this could be one of those times,� said Maureen Allyn, chief economist at Zurich Kemper Investments in New York.

Even optimistic investors who believe the Fed will be successful in heading off a recession will have to hang on through a blizzard of bad news about earnings and economic indicators before the rate cuts start having an effect, she and other observers said.

It’s an open question whether investors, their confidence badly shaken by the events of 2000, will have the faith to look past the near-term problems. A further erosion in confidence could hurt both the market and the wider economy, experts said.

“You can get a euphoric response to what the Fed has done, as we saw Wednesday [when the Nasdaq composite index leaped a record 14%], but then reality sets in,� said Michael Strauss, senior economist at Commonfund Asset Management in Wilton, Conn. “The realization is that there will be many more earnings misses.�

Indeed, by Friday, Nasdaq had lost much of its Wednesday gain and finished down 2.5% for the week.

First Call/Thomson Financial, the research firm that tracks Wall Street analyst reports, thinks the S&P; 500 firms will post year-over-year profit declines in the first and second quarters of this year. Such a back-to-back drop, or “earnings recession,� as it’s called, has not occurred since 1991.

Another source of concern is stock valuations. Although valuations have fallen--Nasdaq had its worst calendar year in history in 2000 and the index has plunged 52% from its March peak--many of the biggest Nasdaq and S&P; stocks still trade at historically stratospheric price-to-earnings multiples.

Can the market launch a sustainable rally with so many of its leadership stocks already so pricey?

Subodh Kumar, chief investment strategist for CIBC World Markets in Toronto, thinks it can.

Kumar predicts a “fairly classic� positive response by the stock market to the Fed’s easing. He said the economy is not as weak as Wall Street fears and that by the end of the year corporate profits will be back on an up trend. The market, which always sniffs out such a turn ahead of time, should be in recovery months earlier, he added.

Investors, with their negative mind-set, are ignoring the probability that the Fed’s dramatic half-percentage-point cut is just the right medicine, Kumar said. They’re dwelling instead on the less-likely idea that the Fed knows something terrible--problems in the banking sector, for example--that the rest of us don’t know. To Allyn and some fellow pessimists, however, problems with the credit system--if not the banks specifically--are far from a longshot.

“This has been the mother of all credit binges,� Allyn said. “The proportion of American housing stock that is mortgaged has never been this high. There are massive amounts of corporate and financial-sector leverage.�

When most credit was supplied by banks, the Fed, as the top banking regulator, had far greater power to ease a credit crisis by promising to bolster weak institutions or to relax enforcement of lending standards for stronger ones.

But today, most of the credit that fuels consumer and corporate borrowing comes from the capital markets, both in Wall Street and abroad.

The financing wave of the last few years has created such overcapacity that bond buyers may conclude they’ll never get a decent return on new investment, so they’ll stop buying and shut credit down, Allyn said.

“The Fed can’t make an insurance company go out and buy mortgages, or make Europeans buy our corporate bonds,� she said.

Seattle fund manager William Fleckenstein, a perennial “bear� who makes his money betting against stocks, thinks that Alan Greenspan’s Fed will be shown to have been one of the most reckless in history, bailing out the markets time and again with rate cuts rather than letting investors learn that mistakes have consequences.

“I don’t want to be Calvinistic and say people have to suffer for the sake of suffering, but when you try to subvert the business cycle you wind up with an epic collapse,� he said, raising the specter of a years-long decline like Japan’s.

More sanguine is Robert D. Hormats, vice chairman of Goldman Sachs International. He believes American business is far more efficient than corporate Japan was when its real estate and stock market bubble popped in 1990. Moreover, Japanese officials were slower to react with rate cuts, and they erred by raising taxes in the mid-1990s before the recovery was in place.

Still, the Fed itself was a bit slow on the trigger, according to Hormats.

“If they’d acted earlier, we wouldn’t have so much trouble re-instilling confidence,� he said.

Interest rate cuts take at least six months to work their way through the economy, but what’s needed now is quicker action, he said.

Tax cuts are at the top of the agenda of the incoming Bush Administration, but the Bush program is “back-loaded,� with the biggest cuts coming five or more years from now, Hormats said.

He recommended a more modest but faster-acting plan that would deliver quick cuts to people in the lower tax brackets, “where they tend to spend it more quickly.�

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Worried Wall Street

Investors reacted to the Federal Reserve’s cut in its key short-term interest rate to 6% on Wednesday by pushing Treasury security yields even lower. It was a signal to the Fed that it must cut further to forestall recession, some analysts say.

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1-year Treasury bill yield, weekly closes

Friday: 4.63%

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Source: Bloomberg News