Traders need a new stock market playbook for these rate cuts

(Bloomberg) — Wall Street traders face a unique challenge in placing bets on the stock market now that the Federal Reserve has begun cutting interest rates: History is no longer a guide.

Bloomberg’s most read

The classic trading playbook for when rates are falling is to buy stocks in sectors considered defensive in nature because their demand is impervious to economic conditions, such as consumer staples and health care. Another popular play is stocks in industries that pay high dividends, such as utilities.

The reason is that the Fed typically cuts borrowing costs to fight a weakening economy or to stimulate one that is already mired in a recession. During those times, companies in growth industries like technology tend to suffer. But that’s not happening now.

Rather, the economy is growing, stock indexes are hitting all-time highs, corporate earnings are expected to continue expanding, and the Fed just stepped up with a half-percentage-point rate cut to begin its easing cycle. There is no manual for this.

“With the Fed opting for a jumbo rate cut amid fairly weak financial conditions, it’s a clear signal for equity investors to be more on the offensive,” said Frank Monkam, senior portfolio manager at Antimo. “The traditional play of defensive stocks, such as buying utilities or consumer goods, may fail to see much traction.”

So where do investment professionals look?

Financing is a good place to start, according to Walter Todd, president and chief investment officer at Greenwood Capital Associates LLC. He takes shares in Bank of America Corp., JPMorgan Chase & Co. and regional banks such as PNC Financial Services Group Inc.

“This rate cut by the Fed should reduce the cost of funding,” he said. “They should be paying less on deposits than they were two days ago, so that should help their net interest margin.”

David Lefkowitz, head of US equities for UBS Global Wealth Management, also likes financials, as well as pockets of the industrial sector closely tied to a strong economy.

No history

This position is contrary to what history would suggest. In four bearish cycles over the past three decades, investors have chased so-called safe-haven stocks such as utilities, consumer staples and healthcare, which pay hefty dividends and are popular with income investors when bond yields fall , according to data compiled by Strategas Securities.

The story continues

Looking six months after the first rate cut in four cycles, the best performing sector was utilities, up 5.2% on average, Strategas data shows. And the tech sector was the worst performer, down 6.2%, with real estate, consumer discretionary and financials also among the groups that struggled the most.

Overall bullish positioning when the Fed cuts rates and the economy holds up is a historically winning play. Since 1970, the S&P 500 has risen an average of 21 percent in the year after the first tapering of an easing cycle — as long as the economy avoided recession, according to data from Bank of America Corp.

Moreover, eight of the last nine easing cycles have occurred when profits have stopped. But profits are now widening, favoring cyclicals and large-cap stocks, BofA’s head of U.S. equities and quantitative strategy Savita Subramanian wrote in a note to clients on Friday.

“There is no Fed playbook — every easing cycle is different,” Subramanian wrote.

Right now, it looks like investors are diving back into big tech stocks and other growth corners of the market. Hedge funds were net buyers of U.S. technology, media and telecommunications stocks at their fastest pace in four months last week, according to Goldman Sachs Group Inc. data.

“Euphoric Consumer”

Meanwhile, others are drawn to stocks that would benefit from increased spending by Americans now that interest rates are falling.

“You’re going to have a euphoric consumer,” said Phil Blancato, chief executive at Ladenburg Thalmann Asset Management. “Seeing the reduction in rebates and an opportunity to get a mortgage will boost spending, whether it’s in the housing market, the auto market or just year-end spending.”

Joe Gilbert, portfolio manager at Integrity Asset Management, sees opportunities in mall operators like Simon Property Group Inc. and in the industrial portion of the real estate sector, including Prologis Inc.

“A lot of these real estate companies have debt that they have to refinance,” Gilbert said. “We think lower rates will definitely help them.”

Utilities were also a popular bet, but not because of their dividends. It’s their exposure to artificial intelligence by driving the technology’s development that has attracted investors, according to Mike Bailey, director of research at Fulton Breakefield Broenniman LLC. In fact, utilities have done so well this year, rising 26% as the second-best performing group in the S&P 500, that their valuations may be stretched.

“It’s hard to know if we’re front-loading all the good news in utilities,” Bailey said. “It looks like we probably won’t see another wave of top performance for these.”

That said, with this wild run, anything seems possible – at least for now. Investors shrugged off worries about high tech valuations, heightened volatility, US political uncertainty and slowing hiring. Few of Wall Street’s doomsayers predicted the S&P 500 would eclipse 5,700 before the end of 2024. However, the index enters this week at 5,703, having risen 20% this year on the back of a 24% gain from last year.

“That was the best case scenario,” said Blancato of Ladenburg. “We have the opportunity to probably hit close to 6,000 by the end of the year.”

Bloomberg Businessweek’s most read

©2024 Bloomberg LP