Rate cut could skew investing path toward stocks, gold

— -- If your dog could talk and you asked him if he'd like a treat, his response would probably be something like this: "Yes! Whoopee! You betcha! Woot! Woot! Woot! Pleasepleaseplease."

If Wall Street could talk and you asked if it wanted the Federal Reserve to cut interest rates, its answer would be similar — and only slightly more shameless. Wall Street loves rate cuts even more than dogs love cupcakes.

Current Wall Street consensus says that the Fed's Open Market Committee will cut its key overnight federal funds rate by a quarter of a percentage point, to 5%, at its Sept. 18 meeting. (The consensus is less firm, however, on whether rate cuts will be good for the economy in the long term.)

If the Fed does embark on a round of rate cuts, you might consider increasing your stock holdings, particularly in sectors that respond well when the economy booms, such as financial services and technology. And because rate cuts might also have unfortunate side effects on inflation and the U.S. dollar, you might consider investing in foreign stocks and gold, too.

Wall Street's lust for a rate cut stems mainly from the credit crunch. When lenders are reluctant to lend, interest rates rise, shaky borrowers default and the economy slows. Today's credit crunch results from the collapse of subprime mortgage lending. Subprime mortgages are home loans made to borrowers with shaky credit ratings. As those borrowers have started to default, lenders have become less willing to lend, thereby driving up short-term interest rates.

A credit crunch wreaks havoc on stocks, a fact long known to short sellers, who bet on falling stock prices. Back in the 19th century, very wealthy speculators would yank money from their bank accounts, making less money available for lending, driving up short-term interest rates and causing stocks to fall. Three robber barons — Daniel Drew, Jim Fisk and Jay Gould — made a fortune in 1868, and nearly collapsed the financial system, by doing just that. Ah, the good old days.

But credit expansion, the opposite of a crunch, is good for stocks. When the Federal Reserve pumps money into the financial system, it makes more money available to lend, driving rates down. Lower interest rates stimulate the economy, lower companies' cost of borrowing and make stocks look more attractive in comparison with bonds and bank CDs.

A recent study by the CFA Institute found that tweaking your investments according to the Fed's monetary policy can be highly beneficial. The stock market averaged a 12% annual return from 1973 through 2005. When the Fed has pursued an expansive monetary policy and lowered short-term interest rates, the stock market gained an average 17.41% a year. When the Fed was raising rates, the stock market gained an average of only 5.34% a year.

You could have substantially improved your record by investing in the correct sectors. Analysts have long divided the market into cyclical stocks and non-cyclical stocks. Cyclical stocks fare well during an economic expansion. Non-cyclical stocks, such as health care, tend to hold up well when the economy is faltering.

The study found that cyclical stocks gained an average of 20.27% a year when the Fed was lowering interest rates. When the Fed raised interest rates, cyclical stocks gained just 2.25%.

"The best message of the study is that that underlying economics make some sense here," says Robert Johnson, managing director of the CFA Institute Education department and co-author of the study. "In a poor market, non-cyclical stocks do better than cyclical stocks. In a booming environment, cyclicals do better than non-cyclicals." (You can read the entire study at www.cfainstitute.org.)

The study used the Fed's discount rate as a buy-or-sell signal, rather than the Fed's more widely used tool of monetary policy, the fed funds rate. The discount rate is a largely symbolic rate, indicative of the Fed's policy stance, Johnson says. The study gauged market performance starting two days after a Fed discount-rate announcement, on the assumption that most people can't correctly guess Fed policy in advance.

Right now, Fed policy is hard to decipher. The Fed said on Aug. 8 that its main concern was that inflation would not moderate as expected. Ten days later it cut the discount rate. On Aug. 31, Fed Chairman Ben Bernanke said it wasn't the Fed's responsibility to protect lenders from the consequences of their actions, but it was ready to help meet the market's liquidity needs.

"The Fed is trying to dance to three different tunes," says James Stack, publisher of InvesTech Market newsletter. Nevertheless, a parade of recent bad news — most particularly in the housing market — now makes a cut seem very likely.

If U.S. rates fall, investors would move money to countries where rates are higher. And that would drive the dollar down further. That's bad news for travelers, because a weak dollar will buy fewer euros. But a falling dollar boosts returns from international funds, so you might consider adding to your foreign holdings.

Gold funds, too, might be a good bet, because lowering rates in a strong economy can be inflationary. Just beware: Someday, Wall Street will beg, and the Fed will say, "No." And when that happens, the market could be a bad, bad market.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. Click here for an index of Investing columns. His e-mail is jwaggoner@usatoday.com.