The Fed Shifts Gears. Should You?
On the eve of his first anniversary as chairman of the Federal Reserve, Ben Bernanke gave Wall Street a big, fat present last week. And while it wasn't exactly what investors ultimately want-an interest-rate cut-it was the next best thing.
For the fifth straight time, the Bernanke-led Fed held short-term interest rates steady. More important, the Fed noted that the nation's inflation outlook is improving even as the economy expands.
The Fed seemed to be sending a signal that further interest-rate hikes may not be on the immediate horizon. And Wall Street celebrated the news, propelling the Dow Jones industrial average to a record-high close.
"What you saw was a bit of a relief rally that the probability of another rate hike this year is now lower than investors previously thought," says Mark Zandi, chief economist for Moody's Economy.com. Barring any unforeseen hiccup in the economy, the Fed probably will remain on the sidelines for the rest of the year.
Does it matter to investors how soon the Fed starts to ease monetary policy? If you're a long-term, buy-and-hold investor, probably not much. But many investors make tactical portfolio adjustments based on the economy's health or geopolitical concerns.
Changeover. Stock market leadership tends to change dramatically once the Fed begins to trim rates. Standard & Poor's chief investment strategist, Sam Stovall, has found that in "plateau periods"-when the Fed has stopped raising rates but not yet begun cutting-the stock market sectors that have fared best have been conservative segments such as healthcare, consumer staples, and utilities.
However, once the Fed actually starts trimming rates, economically sensitive areas of the market lead the way. Since 1945, the best-performing sector in the six months following the first Fed rate cut has been technology. It has posted average gains of 21 percent.
Not surprisingly, the sector that investors were most bullish on heading into this year was technology, according to a Russell Investment Group survey of investment managers done in December.
But that was when it looked as if the Fed might start to cut rates early in the year. Now with rates holding steady, it may be safer to stick with more defensive sectors of the stock market.
This story appears in the February 12, 2007 print edition of U.S. News & World Report.