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How the Fed Rescues Markets

Investor beware? Learn all about a down market with our recession survival guide.

As the U.S. economy slows toward a possible recession, stock investors have a powerful ally in their corner: Ben Bernanke, chairman of the Federal Reserve.

Sure, Bernanke has taken a lot of flak lately over the way the Fed has handled the credit crisis. Some accuse him of being in Wall Street's back pocket. Others say he's fighting the last war by using a policy tool that may no longer work to stimulate the economy, as it has in the past. And still others point to more ominous threats from rate cuts, such as the return of inflation and the falling dollar.

But for those who own shares of U.S. companies, the Fed's moves are likely to pay off in the long run. By cutting rates, the Fed fulfills two goals that help the stock market.

Encouraging investment
To understand why the Federal Reserve lowers interest rates when the economy begins to slow, you have to look at the decision-making process that businesses go through.

Typically, companies have a list of investments that they consider making, and each one requires a certain amount of capital. A company estimates the rate of return from each potential investment. If the cost of raising the capital necessary to make the investment is less than its expected return, then it's profitable for the company to go forward with the deal.

The low cost of capital was a major impetus toward growth during expansion, as companies such as AT&T (NYSE: T  ) , Chevron (NYSE: CVX  ) , and Verizon (NYSE: VZ  ) ramped up capital spending and investment in their businesses. On the other hand, when the cost of capital is high, companies usually reduce capital expenditures, preferring to keep cash on hand and to avoid borrowing to expand their business.

By lowering rates, the Fed aims to cut the costs of capital for businesses, encouraging them to make more capital expenditures. In turn, that should give companies more profitable opportunities, increasing revenue and creating a favorable environment both for the company and its shareholders.

Increasing valuations
The other positive impact lower rates have on stocks is in how shares' values are determined. One popular method, the discounted cash flow model, uses estimates of future cash flow. The model puts more value on cash that will come in over the next year or two over cash flows that are far in the future; to do this, it uses a discount rate that often reflects a company's cost of capital or prevailing rates in the bond market.

To the extent that Fed rate cuts lead to lower interest rates overall, the resulting change in the discount rate used to value shares can lead to a jump in a stock's intrinsic value. For instance, a simple example of a company that will produce $1 per share of profit for the next 40 years produces a stock value of $17.16 using a 5% discount rate, but if the rate falls to 4%, the value rises to $19.79.

Amplifying this effect is the fact that as rates fall, fixed-income investments such as bonds start producing less income. This gives investors more incentive to choose stocks over bonds, leading to increased demand and often putting upward pressure on share prices.

Depending on liquidity
The general assumption is that the Fed's rate cuts will work their way into the overall economy. But the Fed can't do this on its own. It depends on the large financial institutions it works directly with -- Goldman Sachs (NYSE: GS  ) , Merrill Lynch (NYSE: MER  ) , and JPMorgan Chase (NYSE: JPM  ) , for instance -- to extend credit based on the rates the Fed sets.

As long as these and other banks are willing to lend money, then businesses can take advantage of lower rates and bolster investment, thereby helping the overall economy. But the big fear is that if banks stop lending, companies won't just miss profit opportunities -- they may start reining in their business activity, creating a potential downward spiral into a deep recession.

For now, however, that fear hasn't come to pass. And while the recent turmoil at Bear Stearns (NYSE: BSC  ) may not be the last challenge the central bank has to face, the Fed has shown a willingness to think outside the box to protect the financial system and the economy as a whole.

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