Stocks jump on rate cut hopes

NEW YORK (CNNMoney.com) -- Stocks rallied Tuesday afternoon as investors bet that the Federal Reserve will cut interest rates at the conclusion of its policy meeting, currently underway.

Lehman Brothers' earnings and a mild reading on wholesale inflation added to the positive mood.

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The Dow Jones industrial average (up 81.86 to 13,485.28, Charts) and the broader S&P 500 (up 9.98 to 1,486.63, Charts) index both gained around 0.7 percent with roughly 2-1/2 hours left in the session - and 45 minutes before the scheduled Fed rate decision. The tech-heavy Nasdaq composite (up 11.76 to 2,593.42, Charts) rose 0.6 percent.

Stocks slipped Monday as investors mulled slightly hawkish comments from former Fed chairman Alan Greenspan ahead of Tuesday's big Fed policy meeting.

But the tone was more positive Tuesday morning, thanks to a variety of developments - and expectations that the central bank will vote to cut interest rates later today, with a decision expected at 2:15 p.m. ET.

The extent of the cut is in question, with some market participants looking for one-quarter percent, or 25 basis points, and some looking for one-half percent, or 50 basis points. There are 100 basis points in one percentage point.

The "backdrop leading into Tuesday's session was favorable, thanks to relatively sanguine news from Bank of America last night and Lehman Brothers this morning," said Phil Orlando, chief equity market strategist at Federated Investors.

In particular, the PPI report Tuesday morning seemed to set the table for the Fed edging toward a 50 basis point cut, he said. And that's why stock investors could be disappointed later today.

"My best guess is we get 25 in the fed funds rate and a statement that balances out inflation and growth risks, with implications that we could see more rate cuts in the future if need be," Orlando said.

While that would be positive for the economy, it could send stocks lower in the very short run. "We conclude the market is expecting 50, so we could see a negative reaction in stocks."

(For more details on the Fed and markets, click here).

Lehman Brothers (up $2.23 to $60.85, Charts, Fortune 500) reported a narrower-than-expected decline in quarterly income, with strength in its investment banking and management units tempering losses in its fixed-income unit. That unit was hit by the impact of the subprime mortgage fallout and credit market crisis.

Bank of America (up $0.37 to $49.88, Charts, Fortune 500) said late Monday that the credit crisis will hurt third-quarter results in its corporate and investment banking units, but won't drag on overall growth.

Less fortunate was discount brokerage E-Trade (down $0.87 to $13.35, Charts), which after the close Monday cut its profit outlook, saying that tighter credit conditions will force it to get out of businesses that don't deal directly with retail investors. Shares fell 6 percent Tuesday.

A report Tuesday morning showed that the number of foreclosures jumped in August, reflecting the impact of subprime adjustable rate loans resetting.

On a more positive note, prices paid at the wholesale level fell more than expected in August, according to the Producer Price Index (PPI) released early Tuesday. The so-called core PPI, which strips out volatile food and energy, rose a bigger-than-expected 0.2 percent.

The report was especially welcomed by investors due to worries that the risk of higher inflation could limit the Fed's ability to cut interest rates.

Stock gains were pretty broad based, with 27 out of 30 Dow stocks rising, led by Alcoa (up $0.55 to $35.78, Charts, Fortune 500), Caterpillar (up $1.41 to $75.10, Charts, Fortune 500), 3M (up $1.13 to $90.06, Charts, Fortune 500), Walt Disney (up $0.64 to $34.02, Charts, Fortune 500) and General Electric (up $0.56 to $40.74, Charts, Fortune 500).

Among other movers, Best Buy (up $2.10 to $46.64, Charts, Fortune 500) climbed 5 percent after the electronics retailer reported quarterly sales and earnings rose from a year earlier and topped forecasts, thanks to strong sales and a stock buyback program.

Grocery chain Kroger (up $1.96 to $28.98, Charts, Fortune 500) reported higher quarterly sales and earnings and lifted its profit outlook for the rest of the year. Shares jumped 7 percent in unusually active New York Stock Exchange trade.

Market breadth was positive. On the New York Stock Exchange, winners beat losers by more than two to one on volume of 600 million shares. On the Nasdaq, advancers beat decliners four to three on volume of 890 million shares.

Treasury prices fell, pushing the yield on the 10-year note to 4.49 percent from 4.46 percent late Monday. Bond prices and yields move in opposite directions.

U.S. light crude oil for October delivery rose 88 cents to $81.45 a barrel on the New York Mercantile Exchange after hitting an all-time trading high of $81.50 earlier in the session.

Crude ended at a record close of $80.57 on Monday. However, the record price is still below inflation-adjusted highs hit in the early 1980s, which would be equal to at least $95 a barrel today.

COMEX gold for December delivery fell 80 cents to $723 an ounce.

The Fed last cut rates in June 2003, when it lowered the fed funds rate to 1 percent, the lowest level in 45 years. It was the 13th cut since 2001, as the central bank tried to protect the economy after the bursting of the tech bubble, the Sept. 11 attacks and the eventual recession.

After a year of holding steady, the Fed began raising rates in June 2004, so as to move away from the unusually low rates of the previous year, and to protect the economy from the threat of higher inflationary pressures. The Fed ended up boosting rates 17 times in a row until it reached 5.25 percent.

The fed funds rate has stood at 5.25 percent since June 2006, as the Fed has sought to balance inflationary pressure with the threat of an economic slowdown sparked by the housing market collapse.

But the recent rise in mortgage defaults and the tightening of credit have raised expectations on Wall Street that the central bank will have to cut interest rates so as to keep financial markets stable.

The Fed has maintained that it is not the central bank's responsibility to bail out investors adjusting to a different level of risk. However, they are also not going to let the financial markets flounder.

The Fed has already cut the discount rate, which affects bank loans, by a half-percentage point. The Fed has also been pumping billions into the banking system in temporary overnight reserves, so as to keep liquidity flowing.

Now investors are looking for the central bank to cut the fed funds rate, which impacts consumer loans.

Although stock investors often take a knee-jerk reaction in the immediate aftermath of any Fed policy, lower rates have typically sparked stock gains in the months that follow.

A study by Standard and Poor's showed that stocks typically rose six months after the first cut in a new rate-cutting series. (See chart).

S&P's chief investment strategist Sam Stovall looked at 11 rate-cutting cycles between 1945 and 2001, and found that the S&P 500 rose in 7 of those 11 cycles, for an average gain of 12.3 percent.

Looking out 12 months beyond the first cut, the S&P 500 gained an average of 18.8 percent and rose in 10 of the 11 periods.