Fed easing and stock price performance - not a clean history

Conventional wisdon tells us that the stock market, and by the market I mean the S&P 500, typically marches higher under easier monetary policy, meaning that when the FOMC is cutting the fed funds rate, and liquidity is being supplied to the banking system, stock prices work higher for any number of reasons. Some of these reasons include a lower cost of capital for corporations, a lower discount rate on stock market valuation models, higher corporate earnings as higher-coupon debt is re-financed, corporations tend to borrow more at lower rates, as capex projects have lower hurdle rates with lower interest rates, dividend yields begin to look more favorable under lower interest rates, etc. etc.

Lab Thomson, a research segment of Thomson Financial First Call and one of our research providers, published a piece this weekend (weekend of 9/15/07) discussing what past rate cuts have meant for the equity markets: "when examining how equity prices have fared in the one-month period following a recent reduction in the fed funds rate, there was a slight positive bias as equity prices gained in eight instances and fell in five.The average change in the one-month period for the thirteen episodes was -0.19%." If we exclude the aftermath of the 9/11 attack (one episode) then the one-month change in equity prices was a positive 1.17%.

Thomson looked at the most recent round of rate cuts that occurred from January 3rd, 2001 to June 25th, of 2003, and what bothers me about that period is the heavy influence of technology and large-cap growth on the S&P 500 in the late 1990's and early 2000's. Intel, Microsoft, AIG, GE, Pfizer - all the mega-cap winners of 1995 - 1999, had the opposite and negative influence on the S&P 500 during the bear market, as they did positively in the late 1990's.

In other words, even though following 9/11 we had a brief and shallow recession, the equity bear market from March, 2000 to March, 2003, was in my opinion, and with the benefit of great hindsight, simply a valuation correction, or a valuation bear market, rather than a function of any great economic malaise.

My point is that easier monetary policy has in the past lifted stock prices for mainly economic reasons, but that the period from January '01 to June, '03 is not really a representative period given the undue influence of large-cap tech and large-cap growth, and the overvaluation of such during the 1990's. Or saying it another way, if Thomson had looked at the period from 1990 to 1993, then the average gain would likely be much greater than 1.17%.

To conclude, with a 14(x) forward P/E on the S&P 500, the S&P 500 is trading at a much cheaper valuation than in January 2001, and the financials will likely benefit from a return to a normally-sloped yield curve, to a greater degree today than earlier in this decade.

I like the prospects of a strong stock market rally into the 4th quarter of 2007. The market valuation and the leadership groups today are very different than the old leadership of the 1990's and thus are in a better position to benefit favorably from lower interest rates.

long SPY, many large-cap leaders mentioned above