Investors set their sights on interest-rate drop. Battening down portfolios with rate-sensitive stocks
Dark economic clouds seem to loom overhead. Corporate earnings are dismal. Factories are cutting back on production. Imports are scavenging more and more of the United States market. But wait a second. Are the clouds thinning?Skip to next paragraph
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Housing construction -- a crucial economic cog -- just hit its highest level in a year. Some major banks have dropped their prime lending rate to 10 percent, the lowest in six years. The Fed cut its discount rate. And can it be? Congress may actually be haggling its way toward a budget cut.
If you think the skies are clearing and the economy turning around, then you're probably figuring interest rates won't fall much further, business borrowing will soon tighten the credit supply, and the Federal Reserve Board won't need to step in with looser credit.
But much of the so-called ``smart money'' is leaning in the other direction.
``The second quarter will be sluggish at best,'' says H. Alden Johnson Jr., president of Massachusetts Financial Services. ``I don't see credit demand accelerating, so the fundamentals are good for interest rates heading down.''
At such a time, he says, ``Government securities are where I want to be.''
Bond prices surged last week in anticipation of a discount rate cut. Indeed, late Friday the Fed reduced the interest rate it charges on loans to banks to 7.5 percent -- the lowest level in six years. As for stocks, the broader market indexes posted several new highs. The 30 stocks in the Dow Jones industrial average had a more erratic week, but finished up 11.16 points, closing at 1,285.34.
The Dow is not far from its 1,299 high. But William Miller at the Legg Mason Wood Walker brokerage in Baltimore doesn't see a rally here without a catalyst.
Mr. Miller's portfolio is heavily weighted with interest-rate-sensitive securities. Says the research director: ``If interest rates move significantly, it will be down, not up.''
One of Miller's prime performers is ``Fannie Mae'' stock. It is ``one of the world's best interest-rate plays,'' he asserts. ``It is the most leveraged stock on the market. If rates go down, these stocks are going up.''
Fannie Mae (Federal National Mortgage Association) stock is backed by a portfolio of mortgages. As interest rates fall, the value of these mortgages rises and the stock rises dramatically. Fannie Mae also issues bonds in $1,000 denominations. But the stock is much more sensitive to interest-rate swings.
``If one wanted to shoot the works, they'd make much more on the stocks than on the bonds of Fannie Mae,'' in the event interest rates fell, says Keith Broadkin, a bond trader at Massachusetts Financial Services.
Fannie Mae stock is not of the ``buy and hold'' genre. Because of the volatility, it tends to be traded primarily by professional and institutional investors.
Fannie Mae bonds are an income security, now paying from 11 to 11.80 percent interest. The low-yielding Fannie Mae stock, now trading near its 52-week high of 193/8, is a capital-appreciation play.
Regional bank and thrift stocks are high on both Miller's and Johnson's lists of interest-rate recommendations. Banks reap fatter profit margins as interest rates fall. ``Their lending rates come down slower,'' so the spread between their borrowing rate and their lending rate widens, Johnson explains.
But shouldn't one be a bit leery of such stocks in light of the runs on Ohio and Maryland thrifts?
``There are 150 public S&Ls, and 2,500 private,'' says Miller. ``The vast majority of the problems are due to the private thrifts' -- not the public's -- inability to access more capital.''
The banking problems are another reason for the Fed not to raise rates, which would cut margins, Miller contends, and ``if you help the basket cases, all the S&Ls benefit.''
He says another sign of a more lenient credit policy is the recent announcement by Fed vice-chairman Preston Martin of plans to lower the margin requirement on securities purchases. As it stands, investors buying stock may borrow as much as 50 percent of the stock price and use the borrowed stock as collateral. It's unusual for the Fed to bring the margin below 50 percent. Since the Fed began setting margins in 1934, the margin rate has not dropped below 40 percent. The last time the margin changed was in 1974.
``If we can borrow more money, it means the Fed must not be opposed to greater credit creation,'' Miller reasons.
The actions of the Federal Reserve have the most important effect on stock prices, members of the American Association of Individual Investors said in a recent survey. If so, then all eyes will be turned to the policy-setting meeting of the Federal Open Market Committee tomorrow. Chart: Interest rates. Source: Bank of Boston.
Percent Prime rate 10.50 Discount rate 7.50 Federal funds 7.88 3-Mo. Treasury bills 7.40 6-Mo. Treasury bills 7.58 7-Yr. Treasury notes 10.68 30-Yr. Treasury bonds 11.04