Let me start by explaining why the Federal Reserve cut interest rates by 50 basis points (0.5%) at its November 6^th meeting.  The Federal Reserve realized that the slowdown this summer was not a temporary aberration.  Since then, consumer confidence plunged, the unemployment rate rose and the consumer-spending boom that was driving the recovery fizzled. 

The good news is that the aggressive move by the Federal Reserve will continue to expand the money supply.  When the Fed cuts interest rates, adjustable mortgage rates fall, and that puts more money in consumers' pockets.  Essentially, the Federal Reserve is putting more dollars in circulation every time it cuts interest rates.  These new dollars tend to be spent, simply because it burns a hole in consumers' pockets and they can't help but spend it. 

The Federal Reserve's latest cut will help the housing industry, retail sales and all other sectors that benefit from an upturn in consumer spending.  For example, one of my recommended homebuilders, NVR (ASE: NVR) has rallied strongly off its summer low.  Lower rates will continue to help the company's bottom line.

The only types of stocks that will thrive right now are the ones that can profit even if they can't raise prices.  There's no doubt that the Federal Reserve is worried about deflation.  The dramatic drop in business spending has created excess capacity throughout the world.  Business leaders in Mexico, for example, are concerned because they're losing manufacturing business to China, which has significantly lower labor costs. 

Furthermore, oil prices are now plunging in the wake of the U.N. Security Council's resolution.  Falling oil prices will create more deflationary pressure throughout the world in the upcoming months.   The danger with deflation is that consumers may postpone their purchases if they figure out that prices will continue to fall.  Such a deflationary spiral would be devastating (just look at Japan).  Still, I don't think this is likely.  Once Saddam is out of the picture, consumer confidence will improve.

One of the biggest stock rallies in history occurred when the Gulf War began almost 12 years ago.  In 1991, my Model Portfolios gained an average of over 80% as the market soared.  Of course, this isn't an appropriate reason to invade Iraq.  However, whenever the Iraq conflict subsides, oil prices will likely fall further, and the stock market will rally as the uncertainty that has been plaguing investors disappears.

Normally, if the U.S. attacked Iraq, the U.S. dollar would soar due to the respect that the U.S. would command around the world.  However, after the Fed cut rates, the dollar fell sharply against the euro and other major currencies.  If the EU also cuts rates, the dollar might strengthen relative to the euro.  This is important because a weaker U.S. dollar is a windfall for large U.S. companies with vast overseas operations.  However, if the U.S. dollar strengthens, the earnings of foreign companies might be hindered by a stronger U.S. dollar.

The catalyst for the dramatic stock market rally that began on October 9^th was rising intermediate and long-term bond yields.  As bond yields rise, the bond coupon declines causing bond investors to look elsewhere for better returns.  That place was the stock market during the first few weeks after October 9^th.  However, after the Federal Reserve cut rates, bond yields plummeted, causing the principal of bonds to appreciate. 

As a result, the stock market sold off.  The yield curve, which is the difference between short- and long-term interest rates, has "flattened" considerably since the latest interest rate cut.  Now that interest rates have resumed falling, it will benefit the housing market, the banking industry and other interest rate-sensitive industries.

One of my concerns with the stock market rebound since October 9^th is that a lot of "garbage" stocks have rallied.  For example, many telecom stocks soared over 100%.  Some semiconductor stocks and airline stocks jumped over 60%.  The problem I have with these stocks is that almost all of them will continue to post losses or shrinking profits in January and April when the next two quarters of earnings reports are announced.  The primary stocks that soared since October 9^th rallied due to short-covering and are extremely unlikely to emerge as stock market leaders.

There's no doubt that short-covering is an important part of any significant stock market bottom.  However, a stock such as Intel, which missed earnings estimates, cut capital spending and guided Wall Street analysts lower, is extremely unlikely to lead the stock market higher.  Not surprisingly, companies like AOL Time Warner, Cisco, Intel and Lucent performed very well since October 9^th.  It's extremely important that investors do not buy any stocks that have accounting controversies (AOL Time Warner), massive losses (Lucent) or uncertain outlooks (Cisco and Intel).  My advice is to stick with stocks like NVR that will prosper in this low-interest-rate environment.

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