Stocks: When the Rate Music Stops

We all know that investors are anticipators. So it should come as no surprise that the Standard & Poor's 500-stock index advanced an average 19% during the 12 times since World War II after the Federal Reserve Board started a rate-cutting program. Indeed, the S&P 500 was higher 12 months after the first rate cut in 11 of the 12 observations, with 2001 being the only time in which the equity market benchmark was not higher a year after the initial cut.

This time around, even though the S&P is down 6.2% through May 16 since the Fed started its rate-cutting program on Sept. 18, 2007, the market was also still in negative territory six months after the first cut in four of the prior 12 observations, so we still have a chance for the "500" to advance in the next four-and-a-half months.

Enough Momentum?

Equity investors now have something else to consider: Standard & Poor's, as well as many other analysts on Wall Street, believe Ben Bernanke & Co. likely cut the Fed funds rate for the last time for this rate-easing cycle at its April policy meeting. We think the Fed will now sit back and watch three things: First, they'll see if the prior rate cuts have begun to bolster the economy, as it typically takes rate cuts six to 12 months to work their way into the system. Second, the Fed will watch if the tax rebate program will begin to jump-start a sluggish economy.

Finally, the Fed will wait and see if the rate reductions and rebate checks will lead to an acceleration of inflation indicators, which could force the Fed to begin raising rates sooner than the average 13 months after the last rate reduction.

If the Federal Reserve has stopped cutting the Fed funds rate, and thereby halted the delivery of additional fuel to ignite a sputtering economy, should investors panic? Not according to history. Even though what worked in the past may not work in the future, in the 12 times since World War II that the Fed has ended its rate-easing efforts, the building momentum of economic stimulation offered by a succession of interest rate reductions has traditionally had the momentum to power investors' expectations for economic expansion, and has given them courage to add to equity positions.

Small Caps Are the Winner

Indeed, since 1945, in the six- and 12-month periods after the last interest rate cut, the S&P 500 gained an average 9.4% and 18.9%, respectively (excluding dividends). What's more, the market advanced in 11 of 12 observations during both six- and 12-month periods. Six-month gains ranged from 0.6% in 1996 to 23.6% in 1982, while 12-month advances ranged from 6.3% in 1980 to 35.9% in 1954. Only in 1976 did the S&P 500 decline, posting a 3.1% tumble in the six-month period and a 6.3% fall in the 12-month time frame.

In addition to U.S. equities doing well overall after the final rate cut, investors gravitated toward the growth side of the equation, as the S&P 500 Growth index posted a 10.2% average increase six months after the last rate cut vs. the S&P 500 Value Index's 8.6% advance. The story was similar 12 months out as growth beat value 17.4% to 15.4%. Growth also beat value in six of eight observations after six months, but was tied 4-4 after 12 months. Just as with the broader market, only during the 1976-77 period did these indices not rise after the final cut.

Small-cap issues, as measured by the Russell 2000 Index, rose an average of nearly 15% six months after the final rate cut and more than 25% after 12 months, posting increases in all observations.

Looking at performances since 1980, the earliest observation common to all indices, we see that while stocks in general have done well after the last rate cut, growth issues have beaten value stocks, and small caps have outpaced them all.