The Fed's Rate-Cutting Days Are Likely Over

There probably aren't many contexts in which something as uneventful as a pause would be cause for action. But when the Fed pauses, investors had better take notice. I certainly do. It usually means a sea change is at hand. The previous pause, which lasted from June 2006 until September 2007, marked the end of a round of interest-rate increases that began in June 2004. The subsequent cuts in the midst of the credit crisis have been unusually aggressive and even controversial. Two Fed governors voted against the most recent cut, as they did the one before that, in a rare display of open dissent. That makes it even more likely that the Fed's next move will be an increase, although the pause could last months.

So what are the implications for investors?

Generally speaking, everything that benefited from low short-term interest rates should go into reverse, and those that suffered from falling rates should begin to gain. Once the Fed starts raising rates, inflation fears should subside, the dollar should become stronger — indeed, that already appears to be happening — international investments should become relatively less attractive, and exports should weaken. In other words we should be prepared for the opposite of many of the major trends of recent months. Of course, no one knows for sure whether these scenarios will play out. But trends don't last forever, no matter how comforting they become, and one reason they don't is that the Fed's policy decisions change the landscape.

All of this should have a major impact on three sectors that have thrived recently: energy, raw materials, and food and agriculture. All are commodities that trade on global markets denominated in dollars, so the dollar's fall has played a large part in their seemingly inexorable rise. No doubt other, more fundamental factors, such as demand from emerging markets, have also played a significant role. But even the Fed projected a "leveling-out of energy and other commodity prices" along with "an easing of pressures on resource utilization." This may be wishful thinking given that gas prices have topped $4 a gallon in some places. But the Fed should know, since it has the power to influence those prices and seems aware that its recent easy-money policy has been a factor in soaring commodity prices.

While the realization that the Fed's rate cutting is over for now may mean an abrupt change in investment psychology, it's not necessarily bad for stock investors. I've been comparing the recent economic landscape to the 1990-1991 period, when the U.S. suffered through the savings and loan crisis and a recession that, while relatively mild, lasted from October 1990 until June 1991. History never repeats itself, but having lived through that malaise, the subprime-lending and credit crisis and resulting economic weakness (which may or may not turn out to be an actual recession) strike me as similar.

Of course, a pause is more bullish for some stocks than others. I've already suggested that the heyday of energy and commodities is waning, at least in the near term. Back in 1992 energy initially underperformed, dropping just over 7 percent within three months. It later rebounded, and the sector gained 9.8 percent in the year after the pause, which was the same as the broad market. Diversified metals and mining — like energy, a commodities play — dropped 7 percent in the first three months and 5.5 percent for the year.

Health care was the worst-performing sector in 1992, dropping 1.2 percent in three months and a dismal 21.4 percent in a year. In part this reflected the popping of what some considered a biotechnology bubble, and biotech plunged 41.5 percent over those 12 months. Health care has recently been underperforming, so I wouldn't expect the drop to be nearly so severe. Still, this sector traditionally lags as the economy gains strength. Consumer staples, another defensive sector, also lagged in 1992, losing over 10 percent in a year.

What fared best? Financials, industrial cyclicals, utilities, consumer discretionary and information technology, in that order. Within those categories, the top performers included: casinos and gaming (up 92.1 percent in a year); home building (54.4 percent); construction and farm machinery (47.7 percent); consumer finance (39.4 percent); life and health insurance (37.8 percent) and household appliances (32.4 percent). By comparison, as of late spring this year, financials and home builders were already well off their March lows, suggesting a similar pattern may be taking hold.

How am I reacting? It's always hard to part with stocks that have done well, especially after they saw me through the dark days of January and February. But no trend lasts forever. I've started taking profits in my energy and commodity positions, selling call options on Suncor Energy (SU), the Canadian tar-sands operator, and BHP Billiton (BHP), the big Australian mining conglomerate that is trying to take over Rio Tinto (another stock I own and have recommended). I'm not doing anything precipitous. Selling calls seems like a phased withdrawal rather than an abrupt retreat. I always want some energy and raw-materials positions in my portfolio as inflation hedges. But during the recent commodities boom, they've grown far beyond my asset-allocation plan.

I haven't yet put the proceeds to work but am keeping an eye on financials American Express (AXP) and MetLife (MET), as well as battered Whirlpool (WHR; household appliances). All of these companies represent sectors that were among the leaders in 1992, and all experienced sharp selloffs in recent months. American Express has suffered from fears of increasing credit card defaults, but while it has experienced a rise in delinquencies, I believe most of its well-heeled customers will both continue to spend and make their payments. MetLife, with its strong long-term-care and annuity businesses, should benefit from aging baby boomers growing more concerned about providing for the future. I've mentioned before that I'd like to own Whirlpool once the housing market hits bottom; my hunch is that we're close to the turning point. And the benefits to Whirlpool from its acquisition of rival Maytag should also be magnified by any housing upturn.

Many stock traders have a knee-jerk reaction against Fed rate increases. But to me they can be reassuring. They mean the economy is back on track, humming along and less dependent on easy money, and that inflation is at bay. Take advantage of the pause and the next increase should be an occasion to celebrate.