How to invest in stocks after Fed rate cut: Bank of America's strategy

The Federal Reserve would be prompted to further lower interest rates if the trade war deteriorates and harms the economy.

Equity strategists at Bank of America Merrill Lynch examined the factor-investing styles that performed best the last time the Fed carried out a series of rate cuts.

They compared those factors to what has worked since the July 31 cut, and concluded that the similarities they found show that their playbook is working.

Federal Reserve Chairman Jerome Powell tried to assure investors during his press conference that the July rate cut was simply a “mid-cycle adjustment.”

But the market action that ensued showed investors believed otherwise. Stocks around the world slumped and bonds were in high demand amid fears that the trade war was driving the global economy closer to a recession.

If investors' worst fears come true, the Fed would almost certainly need to cut rates more than once to support the economy. As things stand, the trade war is the catalyst that would push the Fed in that direction, according to equity strategists at Bank of America Merrill Lynch.

Amid the uncertainty, they looked back at the last time the Fed carried out a series of rate cuts — 11 years ago as the global financial crisis unfolded. They specifically looked into the characteristics, or factors, of stocks that performed well for investors and which ones did not.

It turns out there are similarities between factors that were successful then and those that have worked since the Fed cut rates on July 31.

While some of these conclusions are based on barely two weeks worth of trading activity, others are underpinned by trends that they believe will be repeated if the Fed enters another prolonged easing cycle.

“With the Fed creating a scarcity of income, dividend oriented strategies have tended to outperform in the early stages of an easing cycle,” said Savita Subramanian, Bank of America's head of US equity and quant strategy, in a recent note.

Indeed, the Fed's rate cut was swiftly followed by a plunge in bond yields, with the 30-year yield nearly hitting a record low. The move was so decisive that some strategists are seriously contemplating the possibility that Treasuries, like some European debt, may soon have negative yields.

With that in mind, Bank of America's playbook found that factors which prioritize returning cash to shareholders have worked best during rate-easing cycles.

“In the 6 months after the initial cut, High Dividend Yield has outperformed its index by 4.1ppt, on average, and High Dividend Growth and High Share Repurchase have outperformed by 2.2ppt and 3.5ppt, respectively,” Subramanian said.

The chart below shows how various factors have stacked up in the six months after an initial rate cut.

If that was then, what is working now？

Bank of America found that quality stocks — preferred in times of economic turmoil for their strong balance sheets — have provided a hedge against steeper losses since the Fed cut rates. While the equal-weighted S&P 500 index fell 3.7%, quality declined by 3.5%.

Associated ETF: iShares Edge MSCI USA Quality Factor ETF (QUAL)

An even stronger performance came from low beta. Stocks that are less sensitive to movements in the S&P 500 — and so are considered safer — have gained 0.7% this month amid the market's sell-off. Meanwhile, high beta has plunged 7%.

Associated ETF: Invesco Russell Low Beta Equal Weight ETF (USLB)

Finally, Bank of America spotted a difference in performance when it comes to market cap. The large size factor is down 3.3%, while small size is down 5.2%.

Associated ETF: iShares Edge MSCI USA Size Factor ETF (SIZE)