The Rate-Cut Rally: Can It Last?

Is this rate-cut rally just another bear-trap bounce? Or does the cut put the stock market safely out of the woods?

In a wholly unexpected move, the Federal Reserve cut short-term interest rates by a half-point to 4.5% Wednesday, sending surprised investors into a buying frenzy. Already buoyant on good earnings news, the blue-chip Dow Jones Industrial Average and the tech-heavy Nasdaq spiked higher shortly after the announcement, and closed the session up 3.9% and 8.1%, respectively, in heavy trading volume.

The Fed -- which has now cut interest rates four times since the start of the year -- had all but sworn it wouldn't cut until its next policy meeting on May 15.

The first time the Fed cut interest rates, on Jan. 3, was also a surprise intermeeting cut. The action sent stocks galloping higher that day and for the several weeks that followed. The Nasdaq sprinted up 16% in three weeks. The broader market, as tracked by the S&P 500 , gained 2.5% in a month and the Dow was 1.5% higher by the end of January. But the three indices subsequently crashed to two-year lows in February and March, slamming many who chased the January rally.

Will it be any different this time around?

Stocks spiked today as they did in January, but they probably won't see the same kind of run-up that they did that month. In the next few days and weeks, strategists say stocks likely will pull back from today's pumped-up levels and trade sideways, but timing the bottom is probably behind us.

According to Lehman Brothers' historical research on the market's reaction to rate cuts, the S&P 500 on average bottoms three months after the Fed starts cutting interest rates. After getting that bottom in place, it recovers 31% over a year's time. Close to half, or 45%, of that gain tends to occur in the first five weeks after the index hits bottom. Technology and financial stocks usually lead the rebound, with tech rebounding fastest in the first six months after the S&P 500 bottoms and financials performing the best among all sectors when measured over a 12-month period.

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The Rate-Cut Rally: Can It Last?

Charlie Reinhard, senior strategist at Lehman, says there's no reason to think this time will be any different. "The tone is improving when it should, based on normal historical timelines," said Reinhard, who noted the S&P 500 hit what looks to be a bottom on April 4, three months and a day after the Fed first cut interest rates. "We expect an average-paced rebound, and on average the same kinds of groups are going to lead that normally lead," he said.

As to what, if anything, could prevent the market from following historical patterns, Reinhard believes only a prolonged and severe downturn in the economy would do it -- something he is not expecting.

Michael Lyons, vice president of investment banking at Morgan Stanley Dean Witter, agreed. "There isn't really anything that would take it past old lows at this point," Lyons said of the market. "I don't see anything negative on the horizon."

Certainly, earnings expectations and stock valuations are at much more reasonable levels than they were in January, when the Fed first cut rates. At the beginning of the year, analysts were projecting, on average, first-quarter earnings growth of 5.2% for the companies in the S&P 500, according to earnings tracker Thomson Financial/First Call. Thomson is now forecasting a 9% drop in earnings for these companies. Technology earnings have been hit even harder. The analyst crowd, which at the beginning of the year expected 4% growth in earnings for S&P 500 technology stocks, now expects earnings to fall 40% compared with the same period last year.

This quarter, in fact, expectations were low enough that some companies have been able to beat targets. So stocks are less likely to fall than they were in January.

Not All Clear From Here

Still, investors can expect some pullback in the next few days and weeks. Valuations are still high on a historical basis. While several first-quarter earnings reports have been positive, and the calls for an earnings rebound in the second half of this year have become a veritable chorus, the first-quarter earnings season is far from over. Plus, much of today's rally was likely helped by short-covering, and investors still need to digest the meaning of the Fed's interest-rate cut (short covering happens when short-sellers' borrowed shares make a sudden move to the upside, forcing the shorts to rush in and "cover" their positions, or buy back the shares before they get too expensive).

"The cut here just caught everybody by surprise, and there was so much money on the sidelines that they fell over one another," said Michael Lyons. "It's too much of a spike here. I think it's going to come back in and trade sideways for a while until we get earnings out of the way here."

Indeed, some of the bigger tech bellwethers -- many of which still need to report earnings -- spiked unreasonably today: chip elephant Intel(INTC) surged 21%; fiber optic giant JDS Uniphase(JDSU) stormed 21.8% higher; networker Juniper Networks(JNPR) zoomed up 21.8%; and storage outfit Brocade(BRCD) jumped 22.8%.

So the bears aren't going away, and could do some more damage in coming weeks. But according to Lehman Brothers' timeline, following today's rate cut, they finally may have begun to beat their retreat.

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