The Stock Market is Riding High on an Easy Policy. Here’s How to Trade It.

Central banks are once again stepping in to stimulate economic growth, and investors who adjust their portfolios wisely stand to gain considerably. This trend of monetary easing has already started with the U.S. Federal Reserve's decision to slash interest rates by half a percentage point earlier this month. China’s central bank followed with a series of bold measures aimed at boosting its economy and stock market. Meanwhile, in Europe, weak purchasing manager surveys have fueled optimism that the European Central Bank (ECB) will also soon implement similar policies.

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As a result, the U.S. stock market has responded favorably, with the S&P 500 reaching a record high recently. One of the major sectors driving this surge is consumer discretionary, which had previously been underperforming due to its sensitivity to economic cycles. The sector, which includes companies such as automakers, leisure services, apparel, and homebuilders, has climbed by 7.3% this month. Big players like Home Depot, Booking.com, and McDonald’s have been instrumental in this growth.

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The stock market’s response seems to signal that lower interest rates are expected to unlock new avenues of credit for consumers, which could further stimulate economic activity. However, this raises the question of whether the shift in market leadership from other sectors to consumer discretionary stocks has more room to run.

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It may come as a surprise that consumer discretionary stocks are doing well during this period. Historically, this sector tends to thrive when the economy is expanding, interest rates are on the rise, and bond yields are increasing. The same holds true for value stocks, which are often seen as bargains, and for equal-weighted indices. However, the current scenario is an anomaly because central banks have been raising rates to combat supply-side inflation. This has led to higher dispersion among different market sectors, meaning that the performance gap between winners and losers has widened. During such times, investors who regularly rotate their portfolios tend to outperform.

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A significant rotation occurred in July when concerns about overvalued stocks and a sluggish economy prompted investors to move away from technology companies linked to artificial intelligence (AI) and into lagging sectors. At that time, consumer discretionary stocks struggled, while real estate investment trusts (REITs), which had previously faced a rough year, became the market's standout performers.

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Interestingly, REITs, which benefit significantly from lower interest rates, have taken a pause during the latest rotation that began in early September after the Federal Reserve’s rate cut. Instead, technology stocks have once again taken the spotlight. This leaves investors wondering if much of the benefits of lower rates have already been reflected in stock prices.

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Looking at historical patterns, the market might still have plenty of upside ahead. Past data, such as the research of economists Kenneth French and Robert Shiller, suggest that when the Federal Reserve embarks on a rate-cutting cycle, the stock market often delivers outsized returns. Whether the economy continues to grow or slides into a recession will be the key determinant. In a growth scenario, the S&P 500’s total return in the six months following a rate cut was typically double the usual rate. On the other hand, a recession has historically led to sharp losses.

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The consumer discretionary sector has mirrored this pattern as well. When rate peaks are followed by a “soft landing” for the economy, this sector has gained an average of 8.6%. However, when the economy experiences a “hard landing,” consumer discretionary stocks have tended to lose 9.3%. Other sectors, including chemicals, financials, and technology, have behaved similarly in response to changes in interest rates.

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So, this current wave of cyclical investments aligns with historical trends. There are valid reasons for investors to dive in. The U.S. economy, although going through a slow period, is not showing signs of a complete collapse, especially with weekly jobless claims reaching a four-month low.

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Today, it’s also easier and cheaper for retail investors to rebalance their portfolios. With a wide range of exchange-traded funds (ETFs) available and brokerage accounts offering nearly free trades, anyone can reposition their investments with ease. However, caution is needed. ETFs tracking the S&P 500 consumer discretionary sector, for example, hold significant stakes in Amazon, which trades more on AI speculation than traditional economic drivers.

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A more strategic approach might be to focus on the non-durable goods sector. Historically, this sector has outperformed consumer discretionary stocks during periods of monetary easing. A similar scenario occurred when Federal Reserve Chairman Alan Greenspan began cutting rates in 1995, which many on Wall Street see as comparable to today.

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However, some analysts worry about the prospects for consumer staples, even though they have benefited from the recent rotation. Lower-income Americans have been more affected by economic hardships than wealthier consumers, which could negatively impact companies like Coca-Cola, Walmart, and General Mills. Yet, if the Federal Reserve’s policies succeed, this demographic could stand to gain the most from lower rates.

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Consumer staples have traditionally managed to deliver positive returns even after recessions. Defensive sectors like healthcare and telecommunications have also shown strong post-peak performance, often outperforming during soft landings, while more cyclical sectors have sometimes lagged.

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In conclusion, following central banks down the rate-cut path doesn’t necessarily have to be a rough ride for investors. With strategic portfolio shifts and an understanding of market dynamics, investors can potentially capitalize on the opportunities created by monetary easing.

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