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Archive for Sunday, March 25, 2001

Stock prices need fall, but investors slow to cheer up

March 25, 2001

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Wall Street likes interest rate cuts everyone knows that. Why, then, has the stock market been so scornful of the Federal Reserve's unusually large half-percentage point cut Tuesday?

Theory, backed by past market behavior, says investors do, indeed, tend to bid stock prices up after significant rate cuts such as the three we've had this year.

Lower rates allow businesses to spend less to borrow money, improving profits or allowing them to borrow more to expand. Lower rates also make it cheaper for consumers to borrow, allowing them to spend more. That lifts corporate sales and boosts profits.

When profits rise, or are expected to, a stock's price follows.

Also, falling interest rates make stocks look better next to competing investments, such as bank savings and money market funds. If yields on those fall, some investors will look for alternatives that may pay better, such as stocks. Rising demand pushes stock prices up.

So why are falling interest rates failing to work their magic on the stock market this time?

Investors, for one thing, are in an unusually deep depression after suffering $4 trillion in stock losses in the last year. They are like someone who can't be enticed out of a darkened room no matter how delicious the smells from the kitchen.

No one likes lower yields on CDs or money market funds, but making 3 percent or 4 percent with virtually no risk looks pretty good next to the prospect of losing money in stocks.

Indeed, Lipper Inc., the fund-tracking company, reported Wednesday that in February investors pulled more money out of stock funds than ever before. It was the first time since August 1998 that more money had flowed out of those funds than in. At the same time, enormous sums flowed into safe, low-yielding money market funds.

It's worth remembering, also, that daily stock movements record only the actions of investors who actually bought and sold that day; most investors spend most days on the sidelines. The daily figures are, therefore, skewed to reflect the sentiments of short-term traders, since these folks buy and sell more often than investors with long-term, buy-and-hold strategies.

But active traders have short-term perspectives. When the Fed cut rates half a point instead of the three-quarters some had hoped for, the disappointment hit short-term traders harder because they bet on quick movements of money between bonds and stocks.

Finally, the current series of rate cuts should be seen in the context of what's really happening in the stock market not so much a disaster as a return to sensible values.

While investors buy stocks in hopes prices will rise, the stock market doesn't exist to ensure that will happen; falling prices are not evidence something is broken.

The market exists to make it easy to buy and sell stocks. Supply and demand, along with a good flow of information, should set prices at reasonable levels where a stock's price reflects a company's current and expected profits.

Historically, stocks have traded at prices averaging about 15 times the previous 12 months' earnings per share. When the Dow peaked in January 2000, it was at 27 times earnings. The S&P 500, at its peak last March, was at 32 times earnings. The only way to get back to 15 was for profits to soar or prices to plummet.

Now stocks are just falling to levels closer to normal.

The Fed's interest rate cuts are likely to help corporate earnings, eventually. But stockholders have been so battered in the past year that they are hard to cheer up. They may believe that rate cuts are an effective tonic, but they want to see results in earnings before they bet stocks will rise again.

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