Stocks & Discount rate

Many people dismissed the Fed Reserve cut on discount rate lending to banks in the middle of August as a "last ditch symbolic gesture". At the end of that day, many stocks markets around the world went up. New research by US academics shows that the rise could have been predicted. Even though the study was done in the US markets, there is plently one can learn from.

This report, available from the CFA institute shows that the discount rate is a good indicator of the direction of monetary policy. When it changes direction, it signals a shift between the expansionary and restrictive monetary policy.

A strategy would then be to buy defensive stocks when the discount rate goes up. These are sectors (resources, utilities and consumer staples) not highly sensitive to the overall economy.
When there is a rate cut, the strategy would then be to buy cyclical stocks (financials, technology).

From 1973 to 2005, this crude strategy would have beaten the market by 3.78% a year. As such, the discount rate seems to be a powerful signal tool.