(Bloomberg) — Wall Street traders face a unique challenge in placing bets on the stock market now that the Federal Reserve has started cutting interest rates: History is no longer a guide.
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The classic trading playbook for when rates fall is to buy stocks in sectors that are considered defensive because demand for them is insensitive to economic conditions, such as consumer staples and health care. Another popular strategy is stocks in sectors that pay large dividends, such as utilities.
The reason is that the Fed typically lowers borrowing costs to combat a weakening economy or to stimulate an economy that is already in a recession. During such periods, companies in growth sectors such as technology often struggle. But that is not happening now.
Instead, the economy is growing, stock indexes are hitting record highs, corporate profits are expected to continue growing, and the Fed just went big with a half-percentage-point rate cut to kick off the easing cycle. There’s no playbook for this.
“With the Fed opting for a jumbo cut amid fairly loose financial conditions, that’s a clear signal for equity investors to position themselves quite offensively,” said Frank Monkam, senior portfolio manager at Antimo. “The traditional play of defensive stocks, like buying utilities or consumer staples, may not get much traction.”
So what do investment professionals look at?
Financial institutions are a good place to start, says Walter Todd, president and chief investment officer of Greenwood Capital Associates LLC. He’s buying shares of Bank of America Corp., JPMorgan Chase & Co. and regional banks such as PNC Financial Services Group Inc.
“This Fed rate cut should lower their borrowing costs,” 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 U.S. equities at UBS Global Wealth Management, also has a passion for financial institutions, as well as sectors within the industrials sector that are closely tied to a strong economy.
No history
That positioning runs counter to what history suggests. In four downturns over the past three decades, investors have chased so-called safety stocks such as utilities, consumer staples and health care, which pay hefty dividends and are popular with income investors when bond yields fall, according to data compiled by Strategas Securities.
Looking back six months after the first rate cut in those four cycles, the best-performing sector was utilities, up 5.2% on average, Strategas data shows. And the technology sector was the worst, down 6.2%, with real estate, consumer staples and financials also among the groups that struggled the most.
Generally, bullish positioning when the Fed is cutting rates and the economy is holding up is a historically winning move. Since 1970, the S&P 500 Index has gained an average of 21% in the year following the first cut in an easing cycle — as long as the economy has managed to avoid a recession, according to data from Bank of America Corp.
Moreover, eight of the last nine easing cycles came when earnings were declining. But earnings are now rising, which is good news for cyclicals and large-cap value stocks, Savita Subramanian, head of U.S. equities and quantitative strategy at BofA, wrote in a note to clients on Friday.
“There is no playbook for the Fed – every easing cycle is different,” Subramanian wrote.
For now, it appears investors are once again piling into big tech stocks and other growth corners of the market. Hedge funds were net buyers of U.S. technology, media and telecommunications stocks last week at the fastest pace in four months, according to prime brokerage data from Goldman Sachs Group Inc.
‘Euphoric consumer’
Others, meanwhile, are interested in stocks that would benefit from increased spending by Americans as interest rates fall.
“You get a euphoric consumer,” said Phil Blancato, CEO of Ladenburg Thalmann Asset Management. “When you see the cuts coming and you see an opportunity to get a mortgage, that stimulates spending, whether it’s housing, auto or just year-end spending.”
Joe Gilbert, portfolio manager at Integrity Asset Management, sees opportunities in shopping centers such as Simon Property Group Inc. and within the industrial portion of the real estate sector, including Prologis Inc.
“A lot of these real estate companies have debt that they need to refinance,” Gilbert said. “We think lower rates will definitely help them.”
Utilities are also a popular bet, but not because of their dividends. It’s their exposure to artificial intelligence by driving the technology’s development that’s attracting 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 say whether we’re getting all the good news in utilities,” Bailey said. “It feels like we’re probably not going to see another wave of outperformance for those companies.”
That said, with this wild bull run, anything seems possible — at least for now. Investors have shrugged off concerns about high tech valuations, heightened volatility, political uncertainty in the U.S. and a slowdown in hiring. Few of Wall Street’s forecasters had predicted the S&P 500 would top 5,700 before the end of 2024. Still, the index comes in at 5,703 this week, having gained 20% this year after gaining 24% last year.
“This was the best case scenario,” said Blancato of Ladenburg. “We have a chance to probably get close to 6,000 by the end of the year.”
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