OK, investors, what now? Has the Fed ignited a new bull market, despite its shaky start? Or are we being head-faked? Maybe the market is wickedly sucking us in, so we can lose even more money in another dive.
No one knows for sure. But I'm interested in the thinking of investment analyst James Bianco of Barrington, Ill. His strategy turns on a particular market-based clue. That clue is encouraging him to buy certain stock and bond groups, aggressively.
Bianco keeps his eagle eye on a market you probably haven't heard of - the futures contracts for federal funds on the Chicago Board of Trade.
Speculators buy and sell these contracts, based on what they think the Fed is going to do about interest rates. The Fed is believed to play close attention to this market when making its decisions.
Since September, the futures market has expected the Fed to lower rates. What's more, the Jan. 3 half-point cut in short-term rates is only the start, Bianco believes. At the moment, the federal funds market is projecting another 0.5 percent drop at the Fed's Jan. 31 meeting, and another 0.25 percent cut by early March.
Even if the rate cut doesn't go that far, the Fed clearly hopes to cushion the slowing economy, make it easier for companies to borrow money and beat back any recession risk.
Bianco, in a study for the Leuthold Group investment company in Minneapolis, looked at industry groups that respond the most when the Fed is expected to cut rates.
His top picks: aerospace and defense, apparel, data processing services, distillers, HMOs, pharmaceuticals, retail drugs and retail food.
"These stock groups started to gain in mid-September, when the fed funds market first started predicting that the Fed was going to ease," Bianco says. "Since then, they're up more than 35 percent."
Note that the market moves on expectations. These stocks rose when the general market looked weak, in anticipation of a cut in interest rates. With even lower rates expected, however, Bianco thinks they will rise again.
Any rise could be quick, wrapping up the bull market in a couple of weeks. On the other hand, maybe not.
There's another way of looking at these favored groups. They're generally the value stocks - good companies that have been beaten down in price.
The better-value stocks pay at least 3 percent in dividends, aren't overburdened with debt, and sell for less than 12 times projected 2001 earnings, Bianco says.
Over more than 20 years, growth stocks have beaten value stocks, but value stocks do better when the economy slows down.
We're slowing now. Business could sag for at least the first half of this year. (This assumes that business is fundamentally sound, and will respond well to interest-rate cuts.)
The first positive effect of lower rates is always on stocks and bonds. It often takes two rate cuts to re-establish a rising trend.(Incidentally, here's a paragraph to tuck away for the next interest-rate cycle: When the Federal Reserve is expected to raise interest rates, the most interesting stock groups are advertising firms, retail electronics, consumer electronics, electrical components and equipment, Internet retail, investment companies, photography, the Big 10 technology companies and telecommunications equipment.)
Some stock groups, such as high tech, did well in the '90s in any interest-rate climate. Bianco focused on groups that responded specifically to an expected cut or rise in rates.
Junk bonds have had a dreadful year of falling market prices and high defaults. Disappointed investors have been pulling money out of high-yield bond mutual funds for many months.
But Bianco has a rosier view.
The Merrill Lynch high-yield bond index now yields 14 percent, with a 6 percent default rate. Even if defaults go back to the worst levels of the 1990 recession over the next two years, investors could earn perhaps 5 percent, he says.
Alternatively, if the rate of defaults improves only slightly and yields drop to 11 percent, you could be looking at a 50 percent gain.
For playing junk bonds, Bianco recommends the largest possible high-yield mutual funds, such as those run by Vanguard or Fidelity. They're the most likely to reflect the junk-bond index and diversify your risk.
Washington Post Writers Group