Fed Rate Cuts Don't Ensure Asian Stock Gains

While it's true that, on average, stocks in Asia tend to rally in the months after a rate cut, it turns out there are a number of caveats to this generalization.

Wondering what's in store for Asian stock markets if the Federal Reserve cuts rate? Keep wondering. While it's true that, on average, stocks in Asia tend to rally in the months after a rate cut, it turns out there are a number of caveats to this generalization. It isn't true, for example, when stock valuations are high, and it certainly isn't true if the U.S. economy falls into a recession despite the cut. So depending on how you slice it - based on past performance - the outlook for Asian stocks in 2007 is pretty good...or pretty bad. What that likely means is the only thing to expect for certain is stock market volatility is going to continue and that rallies that follow short-term sentiment higher as the first cut approaches are probably a good point at which to be unloading stocks - not buying them. Economists, strategist, and futures traders have piled into the consensus the Federal Reserve will cut rates in September, and keep doing so for a while. Fed Funds futures contracts in Chicago are pricing 82% odds that the Fed will cut a full percent out of its benchmark interest rates by December. Given that, analysts have started to look at what's in store for stocks in the wake of the first move - expected in just a few weeks. Looking at six prior instances of Fed easing, UBS strategist Sakthi Siva notes the average gain in Asia (excluding Japan) in the twelve months following an easing is about 14%. But when stock valuations are "stretched," stocks fell in the year following an easing. That was the case in two of the six instances she examined. In 1987 and 1989, stocks were trading at 24 and nearly 23 times earnings respectively, higher than usual, and they fell in the wake of the rate cut. Siva's numbers do show stocks can stage rallies in the month ahead of a cut - about 5% on average - even if shares wind up losing ground in the months that follow. The good news is Siva thinks that valuations aren't stretched these days - with Asia ex-Japan trading at just under 16 times earnings - and that the U.S. economy looks set to slow, not fall into recession. That bodes well for stocks, Siva thinks. But a similar analysis by Citi Investment Research's Markus Rosgen argues the opposite case. Rosgen notes that both times the Fed cut rates with Asia's stocks at relatively high valuations on a price-to-book-value basis, markets fell. And on a price-to-book value basis, stocks are higher now than they were in both those instances. The average price-to-book-value in periods when the region actually rallied was 1.2 times, Rosgen notes. And the average price-to-book value level when stocks fell was 2.3 times. Today that measure sits even higher, at 2.6 times. Still, Rosgen's caution-inspiring analysis doesn't mean stock traders have to run for the hills. Rosgen notes financial, real estate, telecom and utility stocks tend to do well in rate cutting cycles. Three of these - telecom, utility and financial stocks - are among the least popular sectors in Asia at the moment, based on surveys of fund manager weightings. "In other words, we have a well flagged Fed rate cut both from the market and the Fed itself, and yet in terms of their sector allocations, investors are totally ignoring it," Rosgen writes.