The Fed is About to Cut Rates: Quality Stocks are Set to Shine

By Mike Burnick

Fasten your seatbelts: It’s Fed decision week.

Tomorrow afternoon, at about 2:00 p.m. Eastern, the Federal Reserve will announce its latest updates and changes to U.S. monetary policy. The whole market will be watching, eager to find out just how far the Fed is willing to go as they start to slash rates. The biggest question is, will it be a moderate interest rate cut of 0.25%… or a super-sized cut of 0.50%?

And while a cut of some size is seen as a certainty, thanks to comments from Fed chair Jerome Powell, this uncertainty over sizing could mean trouble; investors are impatient for the Fed to get on with easing interest rates already. That’s why anything less than a 0.50% rate reduction could prove disappointing for markets – and stock prices could pay the price.

But eager investors should be careful what they wish for…

In the last five rate-cutting cycles since 1990, the Fed opened with a 0.50% cut only twice – once in 2001, and once in 2007. Both of these larger rate cuts resulted in steep market losses… because those big rate cuts were made in response to an already weakening U.S. economy.

Granted, a sample size of five is too small to draw meaningful conclusions. But for those who think the Fed should go big or go home, a large rate cut could send the wrong message about the economy.

Market Volatility is on the Rise

Regardless of the Fed’s decision tomorrow, there’s one thing you can count on for sure: we should expect plenty of volatility from here. That’s because third-quarter earnings loom large in October – followed by election day the first week in November.

Historically, the period just ahead of us includes some of the worst weeks for S&P 500 returns, as shown in the weekly seasonality chart below:

On top of the seasonality headwinds, periods of falling interest rates also tend to coincide with rising market volatility – and a weaker economy as well.

Amid uncertain markets, one of the best solutions to the volatility is to stick with high-quality stocks. That’s because quality stocks are among the best performers when interest rates are declining:

Sticking to quality names works especially well when it comes to small-cap stocks, with a market capitalization of between $250 million and $2 billion. These names outperform the Russell 2000 index overall by nearly 1.5% per month (that’s roughly 18% annualized)!

But quality large-cap stocks also outperform the S&P 500 – by roughly 10% annually.

In other words: You can’t go wrong with quality, large or small – especially when interest rates are falling and volatility is rising. And with the help of a few simple TradeSmith Screener filters, you can uncover quality stocks for your portfolio quickly and easily.

Search for Quality with TradeSmith Screener Tools

Now, let’s dive right in. Be sure you are logged in to the TradeSmith Finance platform.

To access the TradeSmith Screener, click Invest from your Dashboard and select the Screener tab. Then, click on the green + Create new screener button to get started.

As a reminder, access to our Screener tool is available to Premium-level (or higher) subscribers of our Ideas by TradeSmith service, as well as those with Trade360, TradeSmith Essentials, and TradeSmith Platinum subscriptions.

And to add our proprietary Business Quality Score to your list of available tools, you’ll also need to be subscribed to Ratings by TradeSmith and TradeStops Pro or TradeStops Elite.

Here’s a screenshot of the custom screener I built to find quality stocks ahead of the upcoming volatility. Select + Manage Filters to get customizing, and you can add the filters shown below:

I have full access to the breadth of our TradeSmith tools via my Platinum subscription, so you may see features here that are not available to you. If you’d like to add them to your toolbelt, simply contact us at 888-623-0858 to find out more about those options.

Here’s a breakdown of the filters I used for this screener:

  • Country of Exchange & Asset Type: I start by casting a wide net by including all U.S. stocks. However, you could easily narrow your results further by focusing on just small-cap stocks, only large-cap, or anywhere in between.  

  • Business Quality Score (BQS): This comprehensive TradeSmith formula ranks all stocks by quality based on various metrics – including growth, valuation, safety, and payout. As my colleague Jason Bodner mentioned in our earlier interview, it helps to find the “best of the best.” I set this filter to 80 and above to get only the top 20% of stocks we’ve ranked.

  • Free Cash Flow Yield (FCF): Free Cash Flow Yield is one of my favorite metrics to judge stocks by – and it’s a great guide to find outperforming stocks. Cash is KING when markets are uncertain, after all. Here, I’m looking for stocks with FCF yields above 6%. That’s twice the S&P 500 Index’s average FCF of just over 3% – so it’s a good starting point. You can always adjust lower or higher for more or less results if you wish.

  • Seasonality: The next four filters are based on the seasonal trading patterns identified by our TradeSmith algorithms after scanning thousands of stocks on the market. I start with a Seasonality Pattern Accuracy Rate greater than 80%, to find consistent patterns based on historical performance. Next, I set Seasonality Pattern Average Return to more than 5%. Again, you can adjust this higher for fewer results.

  • Seasonality Years Under Review: I set this filter to search across All Years, to cast a wider net, and Days to Seasonality Pattern Start Date I set between 0 (that’s today) and 45 days out.

Running this screener gave me 57 stocks to examine based on my filter settings. I’ve included a screenshot of the top 10 stocks in the list below:

This list is sorted by descending BQS – to get the highest-quality stocks at the top of the list. But you could just as easily sort by any metric like FCF yield, dividend yield, or any other filter. You might consider sorting by Market Cap, to zero in on just the small-cap stocks that perform particularly well when interest rates decline.

There are plenty of recognizable names on this list – including energy MLP Antero Midstream (AM), asset manager T Rowe Price (TROW), and tech-giant Alphabet (GOOGL), just to name a few.

Simply click on the highlighted icon in the Seasonality column to see each stock’s upcoming seasonal statistics.

For instance, natural gas producer Dorian (LPG), number 8 on my list, is a small-cap stock that also has back-to-back bullish seasonal patterns coming up: From Sept. 30 to Oct. 25, LPG sees average returns of 7.5% occurring 90% of the time – and from Oct. 26 to Nov. 25, LPG averages a 14.98% return with the same frequency.

That’s a compound return of 23.6% for LPG in just a two-month window. You’d better believe I’ll be adding LPG to my watch list – and setting a calendar reminder for Sept. 30!

Mike Burnick’s Bottom Line: It’s been a long time coming for investors, but the wait is finally over. The Fed is set to start cutting interest rates tomorrow afternoon. But the reality is, markets often turn volatile when rate cuts finally happen – due to uncertainty about the economy. Add to that the typical seasonal weakness seen from September through October, and you’ll want to consider having high-quality stocks in your portfolio. Better yet, shore up your portfolio with quality stocks that also have positive historical seasonality! Our TradeSmith Screener tools – combined with our proven Business Quality Score, Free Cash Flow Yield, and Seasonality indicators – can quickly and easily help you find stocks that fit the bill.

Good investing,

Mike Burnick
Senior Analyst, TradeSmith

P.S. Today, I used our TradeSmith Screener tool to find stocks set to weather the upcoming volatility. But the filters I used to find those high-quality stocks – and the Screener tool itself – only scratch the surface of what TradeSmith can do to power up your portfolio and prepare you for any market scenario.

Our team is always researching, workshopping, and developing new tools and strategies to keep you well-equipped – and we’ve launched a new weekly newsletter to keep members updated on everything happening in the TradeSmith ecosystem. It’s called the Platinum Roundup, and it’s a feature exclusive to our TradeSmith Platinum subscription.

Platinum gives you access to the full suite of tools and services provided by TradeSmith, as well as exclusive benefits like extra webinars, the Roundup and its weekly recaps and feature previews, and the first chances to see our latest research.

TradeSmith’s CEO Keith Kaplan is extremely excited about what’s coming to TradeSmith and to Platinum in the coming months – and he’s just as excited to share the details. To find out more about TradeSmith Platinum and all the latest developments, click here to hear it straight from Keith.