Stocks surge on rate cut

NEW YORK (CNNMoney.com) -- Stocks rallied Tuesday after the Federal Reserve cut a key short-term interest rate by a half-percentage point, reassuring investors that it was taking aggressive action amid the credit and mortgage market meltdown.

The Dow Jones industrial average (Charts) jumped 335 points, or around 2.5 percent, according to early tallies. The broader S&P 500 (Charts) index gained around 2.9 percent. The tech-heavy Nasdaq composite (Charts) rose 2.7 percent. The Russell 2000 (Charts) small-cap index gained almost 4 percent.

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"The market reaction is pretty clearly 'Hallelujah'," said Stuart Hoffman, chief economist at PNC Financial Services Center.

Treasury prices extended earlier losses on the decision, lifting corresponding yields. Oil prices closed at a record high for a second session.

Here's a look at what was moving near the close.

The Federal Reserve voted to cut the fed funds rate by a half-percentage point to 4.75 percent. It was the first time the central bank had cut the fed funds rate since June 2003.

Most stock market participants were expecting a cut, with the disagreement about whether the cut would be 25 basis points, or a quarter-percentage point, or 50 basis points, or a half-percentage point. There are 100 basis points in one percentage point.

"This is a good first move that will give aggressive confidence and aggressive relief to the credit markets and the consumer," said Georges Yared, chief investment strategist at Yared Investment Research. "It's good that they didn't do this incrementally 25 points at a time."

The Fed also cut the discount rate for the second time in a little over the month, lowering the largely symbolic rate by a half-percentage point.

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 help protect the economy and to keep financial markets stable.

The decision Tuesday seemed to reassure investors that the central bank will do what it can to keep liquidity flowing and try to protect the economy from falling into a recession.

The accompanying statement said that although economic growth was moderate in the first half of the year, the tightening of credit conditions could intensify the housing correction and drag on growth going forward.

The bankers said the cut was intended to "help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time. (Read the full statement here.)

"Reading between the lines, the tone of the statement is that the door is still wide open for cuts in the fed funds and discount rates at upcoming meetings," said Hoffman.

Stock gains were broad based, with 28 out of 30 Dow stocks rising, led by financial components JP Morgan (Charts, Fortune 500), American Express (Charts, Fortune 500) and Citigroup (Charts, Fortune 500).

Economically-sensitive issues such as Alcoa (Charts, Fortune 500) and Caterpillar (Charts, Fortune 500) also jumped, along with stocks sensitive to consumer-spending trends such as Wal-Mart Stores (Charts, Fortune 500) and Walt Disney (Charts, Fortune 500).

Stocks had risen earlier in the session following a mild inflation report and a smaller-than-expected drop in Lehman Brothers earnings.

Lehman Brothers (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 (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 (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 5 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.

Among other movers, Best Buy (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 (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 eight to one on volume of 1.56 billion shares. On the Nasdaq, advancers beat decliners by more than three to one on volume of 2.1 billion shares.

Treasury prices fell, pushing the yield on the 10-year note to 4.50 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 settle at $81.45 a barrel on the New York Mercantile Exchange, a record closing high for the second session in a row.

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 rose 20 cents to $724 an ounce.

Tuesday's news sparked a knee-jerk positive reaction in stocks. But the forecast could be good longer term as well.

Lower rates have typically sparked broader gains six months after the first cut in a new rate-cutting series, according to a study by Standard and Poor's. (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.

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.

Prior to Tuesday's cut, the fed funds rate had stood at 5.25 percent since June 2006, as the Fed struggled to balance inflationary pressure with the threat of an economic slowdown sparked by the housing market collapse.