How to Beat the Market by Playing the Federal Reserver US Interest Rate Cuts

By: Hans_Wagner

On October 31, 2007 the Federal Reserve lowered the Fed Funds and Discount rates by 0.25%. This is the second Fed Funds Rate reduction and the third for the Discount rate. In their announcement the Fed hinted that investors should not expect another rate move at their next meeting on December 11, 2007. In the hours after the announcement the market jumped up. The next day it fell on bad news from Citigroup regarding sub-prime mortgage loan write offs.

The question for investors is what they should do now. The chart below from www.chartoftheday.com indicates that the Fed Funds Rate is in a long term downward sloping channel. If the trend holds true then we should expect further rate reductions over time.

In a study titled Sector Rotation and Monetary Conditions by Robert Johnson, C. Mitchell Conover, Gerald R. Jensen, and Jeffrey M. Mercer and mentioned in the 10/12/2007 Point of Interest concludes that the markets go up when the Federal Reserve lowers either the Fed Funds or Discount rate at least two times in a row. Bill Gross the manager of the largest bond fund believes that the Fed Funds rate will fall another 1.00% to the 3.5% area over the next 12 months. However, not every sector and company will benefit equally. Value investors often look to sectors as they seek to buy good companies that are at a low relative price. Value Investing: From Graham to Buffett and Beyond by Bruce C. N. Greenwald, Judd Kahn, Paul D. Sonkin, Michael van Biema is a good book on value investing as practiced by Warren buffet, the best investor in the world. So what does this really mean for investors? 

Basic Themes

Let's start with a few basic themes and then discuss some potential action on the part of investors over a couple of relevant time frames. 

Dollar will go lower so all things priced in dollars will go up in price to compensate. This includes oil, metals, and agriculture products. Investors should look to buy companies that produce hard things, As Dennis Gartman, a noted commodity trader and publisher of The Gartman Letter said; “own something that when it falls will hurt your foot”. These have been doing well but they will continue to do well.

U.S. exports should continue to grow as the price of goods and services made in the U.S. will be lower relative to other currencies. Investors should look for companies that have a substantial export component to their business.

Inflation is likely to go higher. The price of goods and services that are imported and not tied to the U.S. dollar will rise. Companies that import their products are likely to encounter higher prices. This is especially true for retailers who source production of their products to overseas countries whose currencies are not tied to the U.S. dollar.

Foreign investors may not buy as much U.S. debt if they can get better rates elsewhere. This may cause longer term rates to rise increasing the borrowing costs for companies that use the debt markets.

The Major Sectors

Being in the right sector is very important if you wish to beat the market. Fortunately, there are a number of ways to track each sector. For today's purposes we will discuss the nine major sectors and for your reference the Sector SPDR Exchange Traded Fund (ETF) that tracks the sector. The link will take you to a www.StockCharts.com annotated chart for the sector.

Next three to six Months

Continued global growth will be the driving theme with the U.S. transitioning through the credit and housing problems which will be on investors' minds and slow growth in the U.S. This will primarily benefit the companies that handle and make heavy things, especially the materials sector and the industrials. 

Technology should continue to outperform the S&P 500; especially the build out of the “Web 2.0” internet, wireless as the next generation of broadband comes online, and software that helps improve productivity of just about everything. Semiconductors have been lagging as many have become commodities, though they might catch up at some time in the future.

Energy, especially the refiners beginning in February, just before the start spring when they start to convert to summer grades stock up for the summer driving season. I expect the crack spread to widen, possibly up to the level of 2007 with alternative fuels providing some offset as the come on line.

Consumer goods both staples and discretionary will continue to match the market as the slow down in the U.S. affects their sales. Those with substantial international sales will perform better as they benefit from the growth in those countries.

Most of healthcare will struggle as the rhetoric grows from a better healthcare plan for the U.S. driven by the coming Presidential election. There will be some firms that have a unique franchise that will perform well, especially those that improve the productivity of the development new drugs and delivery of healthcare services.

Avoid financials as they will continue to have unhappy surprises as new problems with their vast portfolios of bad loans come to light.

Utilities should continue to do well as lower interest rates increase the value of their dividends to investors.

Six Months to a Year

Global growth will continue though there are some who believe after the Summer Olympics in China that a slow down is inevitable. We might see slower growth, but growth will still be taking place driving the demand for materials, energy and infrastructure.

Look for selected areas of technology to continue to beat the S&P 500 as the transition to the Web 2.0 continues and new and exciting capabilities become available to consumers and businesses. There will also be sub-sectors and companies that under perform, so it is paramount to do your homework and be selective.

It will take at least six months before the financials to complete the digestion of the sub-prime mortgage and credit problems. Once they do I expect them to become strong performers most likely starting with the regional banks as they have had the least exposure to the sup-prime loan problem.

Healthcare will still be in the spotlight as the U.S. Presidential election really gets underway causing the sector to under perform. Eventually the aging population in the U.S. and the rest of the world will make healthcare an important sector.

If rates are still coming down then utilities should continue to be a good sector for more conservative investors. Also monitor the growing demand for electricity as utilities will have to increase their power generating capacity over time. This can be an expensive as well as risky proposition as they debate use of coal vs. nuclear.

Over One Year

It will be necessary to assess the continued demand for materials such as copper, iron ore, fertilizer, etc. If the global growth continues as some expect then these sectors should still do well, though not at the same pace as before. Industrial firms may encounter a slow down due to the overheating of the global economies. Review the current demand situation before making any new commitments.

Review the current trend for technology as it is subject to change depending on the strength of the economy and introduction of new capabilities.

We will see more demand for consumer goods both discretionary and staples across the globe as consumers in the BRIC countries and other growing economies earn the income to buy goods and services previously only available to the middle class of more developed countries. It should be a good time to be invested in the consumer companies that are being avoided today.

Financials, especially the big money center and investment banks should do well. As the lower rates help improve their interest rate spread and the large loan write offs of the past year subside.

We should begin to get a clearer picture of what the U.S. government might do regarding healthcare in the U.S. the ongoing aging of the population will drive the demand for drugs and services, though it just depends on what changes the U.S. government might make to change the structure of the sector.

If the economies of the world are growing and interest rates have either reached their low or are going back up then utilities will likely not be the best place to invest. It will be important to assess the status of the world's economies before making the decision.

The Bottom Line

With the Federal Reserve lowering key Federal Funds rates, it is important for investors to be in the right sectors to help them beat the market. In selecting the right sectors investors should develop a well thought theme that articulates their view of the sector and sub-sector. It also helps to have a time frame in mind when performing this important exercise. Many investors read Barron's . A weekly magazine for investors that contains some of the best analysis on companies, markets and the economy to help them develop their themes.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

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