Stocks and Rates

By Sharon Epperson

Watching Alan Greenspan to find out which way he and his fellow Federal Reserve policymakers will move on interest rates is like waiting to see if the groundhog spots his shadow. No matter what the outcome, it's the anticipation, the unknown, that makes everyone so nervous. This time around, investors were hoping Greenspan & Co. wouldn't see inflation's gloomy outline. Instead, they'd proclaim that their efforts to cool off what has been a red-hot economy had succeeded.

That didn't happen. But the Federal Open Market Committee didn't vote to raise interest rates either. After six rate hikes since last June, it decided to leave well enough alone for now.

So what does all this mean for you? With the presidential race in full swing, the Fed isn't likely to make a move on rates for the rest of the year, something most investors seem to have figured out. According to a new PaineWebber survey, more than half said they do not expect an increase in the next three months. And they're betting stocks will jump more than 14% by this time next year.

But don't call your broker just yet. Although the cloud that has hung over the market all year may have been lifted, at least until November, it could be a year before stocks recover fully from the Fed's moves. Sure, share prices often rally right after the Fed stops tightening, but history has shown that such rallies don't last long.

The Fed Funds rate has inched up 1.75%, to 6.50%, since June of last year. David Ranson of Wainwright Economics in Boston looked at 45 years of data and discovered that after a period when the Fed raised rates at least 1%, the market did not respond well for the next year. The Standard & Poor's 500 index has had an average gain of about 13% since 1955. Yet historically the year after the Fed has raised rates, the S&P actually produces below-average returns of about 8%. Then the market gets a big boost the second year out--assuming the rate hikes have stopped--with above-average returns of nearly 19%. Says Ranson: "The good news is that [the market] can reach the same heights it had even before the Fed started to raise rates."

There have been some exceptions. After the Fed stopped tightening rates in February 1995, stocks quickly bolted and kept rising--up 19% in the first six months and 36% for the full year. "The key was getting the Fed off the brakes as inflation expectations went south," says Thomas Galvin, chief investment officer at Donaldson, Lufkin & Jenrette. Galvin is counting on stocks to replay their 1995-96 scenario. So he figures investors should put their money in the same sectors that did best then: health care and technology.

Ranson agrees that a defensive investment strategy--which would include large-cap tech and drug stocks--is best if you're planning to stay in the market. But he advises being very cautious as the recent rate hikes filter down. With the Dow down for the year, NASDAQ basically flat and the S&P up only 2.5%, Ranson says investors may get better overall returns from cash rather than stocks. His suggestion: wait until 2001 to invest more heavily, or at least until there's solid evidence that the Fed's moves have actually succeeded in cooling the economy.

Sharon Epperson is a correspondent at CNBC Business News. You can e-mail her at sharon.epperson@NBC.com