The Fed will calm a stormy market

E-mail Money Magazine editor-at-large Michael Sivy at msivy@moneymail.com.

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(Money Magazine) -- The stock market is in turmoil. Fears of a recession are rising. And experts question whether the Federal Reserve's big interest-rate cuts are enough to save the economy. Does that mean you need to be doing a dozen things right now to protect your investments?

Big shocks would seem to call for big adjustments, and there may be more scary stuff to come. No one really knows how weak the economy will get, for example, or how many additional write-offs banks will report - not to mention how far the dollar will fall or how high oil prices will soar.

All those things are plenty worrisome to stock market pros who get judged on a quarterly basis. But the truth is that if you're saving for the long term, there are only a few key issues you need to consider. Chief among them is the Federal Reserve's interest-rate policy, as a new study confirms.

The Fed's big rate cuts - including the three-quarter percentage point reduction on Tuesday - will eventually revive the economy and turn the stock market around. In fact, based on today's interest-rate picture, the prospects for stocks are much brighter than they were a year ago.

That's because the Fed doesn't just anticipate market trends, it actually causes them, by tilting the playing field when it raises or lowers interest rates.

"We looked at a 33-year time period, and the relationship between Fed policy and stock returns is dramatic and consistent," says chartered financial analyst Robert Johnson, deputy CEO of the CFA Institute and one of the co-authors of a recent study of Fed policy.

The analysts found that from 1973 through 2005, a broad index of nearly 1,000 stocks returned an average of 12 percent a year. But in periods after the Fed began lowering the discount rate (charged for direct Fed loans to banks), those returns soared to 17.4 percent. They fell to a meager 5.3 percent during times when the Fed was raising rates.

These results are only historical averages, of course. There's other evidence that interest-rate changes don't take full effect on stock prices for up to a year, and the market's gyrations could still prove quite unsettling during the next few months.

Nonetheless, the long-term trend is still clear: Given that the Fed first cut the discount rate in August and has continued to do so, history suggests that the tone of the stock market should improve by mid-2008. In the meantime, make sure you're as well diversified as possible.

The other key issue to consider is the level of stock valuations. Although you can't know what the market's next move will be, you certainly can identify times when shares are way overpriced, as growth stocks were in the late 1990s. You couldn't have known when the growth bubble was going to burst, but you would have benefited by slowly trimming your most overvalued holdings.

Today the opposite process is under way. Some sectors are already undervalued, and others should hit bottom within the next six months. You can take advantage of any further market weakness to go bargain hunting, especially in areas such as those in this story.

If you're interested in adding individual stocks to your portfolio, take a look at companies on the Sivy 70 list that are trading at price/earnings ratios below 16 and still appear likely to turn in healthy earnings gains next year.

• Leading computer maker Hewlett-Packard (HPQ, Fortune 500) has been conservative in its earnings expectations and recently projected double-digit gains for the coming year.

• Johnson & Johnson (JNJ, Fortune 500), which is better diversified than most health-care companies, yields 2.4 percent and has raised its dividend for 45 consecutive years.

• And 3M (MMM, Fortune 500), the maker of Scotch tape and Post-It notes, expects growth of at least 10 percent next year. The company gets 64 percent of its sales overseas and has been a major beneficiary of the weak dollar.

There is one depressed stock that I have recently deleted from the Sivy 70. I drop a poorly performing stock only if it seems unlikely to recover its growth potential. That's the case for Washington Mutual (WM, Fortune 500). Not only is the giant home lender suffering from shaky loans, but the mortgage business that is its core franchise also appears unlikely to recover for years.

In place of WaMu, I have added Union Pacific (UNP, Fortune 500), the chief rival to railroad Burlington Northern Santa Fe (BNI, Fortune 500), which is already on the list. Transportation is underrepresented on the Sivy 70, and railroads have an enormous advantage over trucks in a period of high oil prices because of their energy efficiency. The newest locomotives burn 30 percent less fuel than older ones.

Union Pacific hauls all kinds of freight. Building materials are down because of the housing slump. Most other categories, however, are up, including low-sulfur coal from the Powder River Basin in Wyoming and Montana. That business is bound to boom as long as the price of oil remains high.

Union Pacific recently raised its dividend 26 percent, and the stock now yields 1.6 percent. It's true that a recession could depress earnings growth and knock the stock down a bit, but that would actually signal a good time to get on board.