Invest with the Fed

There is an old saying in the US stock market.

“Don’t fight the Fed”

There is also another old saying “if you can’t beat them, join them”

So what happens if instead of investing against the Fed, you invested with them? Luckily I recently came across some research that shows us investing with the Fed could make a significant difference to your returns.

The following is an exert from research conducted by Gerald R Jensen, Professor at Northern Illinios University, Robert R Johnson, President and CEO of The American College of Financial Services and Luis Garcia-Feijoo, associate professor of finance at Florida Atlantic University.

If you like this and want to learn more, you can purchase their book “Invest with the Fed

The Federal Reserve Board of Governors is a little like our Reserve Bank of Australia. One of the Fed roles is to set interest rates, very similar to how our RBA determines interest rates in Australia.

The Fed set several different interest rates but Jensen, Johnson and Garcia-Feijoo looked at two rates in particular. They asked the question – what happens to stocks when the Fed increases interest rates? Is this good or bad for stock prices?

One camp say rising interest rates happen because the economy is improving which should be good for corporate profits and hence stock prices. The other camp say higher interest rates mean it costs companies more to borrow and service debt which means less profits and stock prices fall. Which one is correct?

Rather than guess, they conducted research to find out using 48 years of stock price and interest rate data. Whilst the future is never exactly the same as the past it is often similar so any kind of bias discovered here can guide us with stock tactics in future.

The same three researchers conducted prior research that showed it is not the absolute level of interest rates that matter, but rather the direction, ie are rates going up or down, rather than what level they are at.

They used two different interest rates. The Fed Discount Rate (officially the Discount Window Primary Credit) and the Federal Funds Rate.

The Discount Rate is the rate the Fed charges on loans to member banks and often remains unchanged for long periods of time. At the time of writing this rate is 0.75% and has been since March of 2010. This is viewed as the long term interest rate policy.

They looked at the last monthly change that happened to determine direction. The last change in the discount rate was an increase from 0.50% to 0.75% in March 2010. Therefore the direction of the discount rate is presently up.

The second rate considered, the Federal Funds Rate is the rate on loans the banks extend to each other. Or rather, it is a target level the Fed would like the banks to loan to each other at. This is considered the short term interest rate policy.

Once again the monthly change is what is important and the most recent change was up from 0.11% to 0.12% in April 2015 so the short term policy is up.

The key to classification of interest rate direction is for both to be aligned. Hence if both short term and long term rates are up, we classify the Fed policy as restrictive. If both long and short term rates are down we classify Fed policy as expansive. If we have the case of one up and one down then overall monetary environment is indeterminate

Fed Funds Rate Discount Rate
Up Down
Up Restrictive Indeterminate
Down Indeterminate Expansive

 

The researchers claim such classification leads to a fairly even distribution of monetary policy exhibiting the three classifications an equal amount of time.

Stock Market Performance during different Monetary Conditions

Now we have our monetary conditions classified we can look at stock performance during those periods. First we will look at large cap stocks since January 1966. To define large cap stocks the S&P500 index is used.

From January 1966 to December 2014 the research shows the following annualised performance

Expansive Monetary Conditions Indeterminate Monetary Conditions Restrictive Monetary Conditions
Large-Cap Stock Return (%) 15.18 11.46 5.74
Inflation Rate (%) 2.86 4.17 5.08

 

What we can see is a very large difference between performance during Expansive Monetary Conditions and Restrictive Monetary Conditions. In fact, stock performance during Restrictive periods is just about the same as average inflation during those periods.

Taking a look at small cap stocks we see an even greater impact. The research uses the same January 1966 to December 2014 period and the New York Stock Exchange (NYSE) description of the smallest 20% of companies to represent the small cap sector

Expansive Monetary Conditions Indeterminate Monetary Conditions Restrictive Monetary Conditions
Small-Cap Stock Return (%) 28.39 9.25 5.14
Inflation Rate (%) 2.86 4.17 5.08

 

From this we can see that small cap stocks have exhibited a whopping 28.39% average annualised return since 1966 when the Fed is in Expansive mode. Interestingly during restrictive periods small cap return is almost the same as large cap return at this time.

During indeterminate periods, large caps perform better than small caps.

How can we use this data?

The first point to make is the enormous return offered by small cap stocks during expansive periods. We need to take advantage of that. Second is the outperformance of large caps during indeterminate periods and lastly, during restrictive periods we note both sectors are basically keeping pace with inflation.

Our suggested strategy is to invest in small cap stocks during expansive periods, large cap during indeterminate periods and consider non-stock investments during restrictive periods.  A further interesting piece of research would be to look at gold during the restrictive periods, but we do not have any data to show you on this.

Implementing the strategy

The beautiful thing about this strategy is how easy it is to implement. The Federal Reserve publishes the two key interest rates on their website every month. You can also download all the history. All an investor needs to do is update a simple spreadsheet once per month with two figures. Since the long term rates hardly change, most of the time this will be just one number, once a month.

It is very simple to then determine if the last change was up or down and hence determine the overall monetary conditions and invest accordingly

You can access the rates at

http://www.federalreserve.gov/releases/h15/data.htm

 

Summary

As investors we can choose to invest in stocks or not. We could leave all our cash in the bank, basically risk free, and earn interest. As soon as we invest in stocks we take on the risk of loss. A risk averse investor therefore should only take on stock risk at the best times. This simple approach of monitoring Fed interest policy enables us to easily determine when that best time is.

It is a very simple way of maximising gains whilst minimising risks, something every investor should be trying to do.

 

Important Notice:

Capital 19 (ABN 17 124 264 366) AFSL 441891. Any advice is general advice only and is given without taking into consideration the investment objectives, financial situation and particular needs of any particular person. Before making an investment or trading decision based on this information, the recipient should consider carefully the appropriateness of the information in light of his or her financial circumstances.