More Rate Cuts Ahead

We entered another FOMC watch week with a nice rally today. The S&P 500 closed up 1.75% today, with strong readings across all style categories. The Nasdaq 100 lagged, gaining only +0.89%. The market is anticipating a 50 basis point cut in the Federal Funds rate on Wednesday, as evidenced by the futures market indicating an 88% chance of a 1/2 point cut. A 25 basis point cut is fully priced in at the present time.

This is an extremely over-sold market that continues to bounce. Value is beating growth in the short term, and the sectors most heavily damaged in the past twelve months – financials, insurers, banks, and home builders are making the largest moves. It is clear that the lag effect of the Fed rate cuts that were initiated in August are starting to kick in. The question to be answered in the coming weeks will be if these are the new leaders. To put it another way, should investors begin initiating positions in these sectors?

Clearly mortgage re-finance numbers across the country are spiking higher, especially after the fall in the 10-year Treasury Bond which matched its lowest yield in 40+ years last week. This has given additional ballast to an over-sold market. Some investors compare the 10-year Treasury Bond yield (3.6%) to the earnings yield of the S&P 500 (6.2%), which is commonly known as the Fed Model. The implication is that the stock market is 42% undervalued. This is also an extreme reading, and some value-oriented investors are coming off the sidelines and putting their cash to work.

One last thing: the five worst Januaries since the S&P 500 was created in 1926 had an average decline of -6.8%. The average one-year return after January in these five years was +12.3%, with no negative readings. The average two-year return after January in these five instances was +26.0%, with a high of 42.4% and a low of -8.1%.