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Fed pause won’t help markets

— Investors often like to dream of the perfect world, and their current vision has the Federal Reserve soon ending its two-year interest-rate tightening run and the stock market soaring afterward.

But history argues otherwise. What the past has shown is that stocks tend to follow a more nightmarish path after the Fed pauses a rate-raising cycle.

Of course, looking in the rearview mirror might not accurately predict what’s to come, but it should alert investors that they can’t count on the market changing its troubled course all that fast.



The Fed has been boosting borrowing costs since June 2004, pushing up the overnight bank lending rate — also known as the federal funds rate — to 5.25 percent in 17 quarter-point steps.

There is growing hope on Wall Street that the Fed could almost be done, which is why all eyes are on the outcome of the central bank’s policy-making committee meeting on Aug. 8.



Higher rates tend to spook investors because they increase corporate borrowing costs, which can eat into profits as well as slow the economy. They also make other investments, like bonds, more attractive and boost returns for savers.

But this time around there is more to investors’ concerns. Worries abound over whether the Fed has “overshot” the necessary rate-raising range by slowing the economy too much to combat growing inflationary pressures, potentially pushing it into a recession in the coming year.

Economists note that while the Fed has been tightening, yields on most long-term U.S. Treasury securities have fallen below those of the funds rate, creating what is known as the “inverted yield curve.” The 2-year note now yields 5.17 percent, the 5-year is at 5.07 percent, the 10-year yield is 5.10 percent and the 30-year is 5.14 percent.

Recent history suggests bad things happen when that occurs.The whole curve has inverted four times in the last 25 years — in March 2000, August 1998, January 1989 and January 1982. In each case, the inversion preceded either a downturn in the economy, a major financial strain or both, according to Merrill Lynch.

All this has unnerved investors in recent months, sending major stock market indices down from their highest levels in nearly five years. Since mid-May, the Standard & Poor’s 500 index and Dow Jones industrial average have lost 6 percent apiece. That’s why investors seem to be hanging their hopes on a pause in the Fed’s rate moves. But looking back at the seven times since 1971 that the Fed raised interest rates more than once during a tightening cycle, the S&P 500 fell on average 2.1 percent between the time the Fed paused and then began cutting rates again. That gap typically lasts six to seven months on average, according to S&P chief investment strategist Sam Stovall.

“Should history repeat itself, and there’s no guarantee it will, substantial equity price appreciation in the period ahead might be difficult to justify” during the plateau period between the Fed’s rate cycles, Stovall said.

Still, this doesn’t mean investors should run from stocks. The key to the months ahead, according to the experts, is to take a defensive stance and focus on stocks that generally do well in an uncertain, and potentially economically difficult, environment. That’s where another history lesson might help.

Stovall looked for the sectors that outperformed the S&P 500 during the plateau period in between rate cycles over the last 35 years. His results: health care stocks outperformed 76 percent of the time, consumer staples outperformed 66 percent of the time and telecom services outperformed 63 percent of the time.

David Rosenberg, Merrill Lynch’s chief North American economist, favors some contrarian thinking. He suggests that investors take a look at the winners and losers from 2003 when the Fed finished its rate-easing cycle by pushing the fed funds rate down to 1 percent in its attempt to fight deflation. Investors should play the opposite today, he says.

For instance, in 2003 consumer discretionary, technology and energy stocks outperformed, as did small-cap shares, while defensive shares like telecom and health care lagged behind.

Of course, the stock market is unpredictable. If it followed the same historical path, there wouldn’t be much money to be made. But at least the past helps map out a potential course.

Rachel Beck is the national business columnist for The Associated Press.


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