Barron's: Follow The Fed
FEBRUARY 5, 2001
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Follow The Fed
The lazy man's guide to timing the market
By Jay Palmer
When the Federal Reserve announced a half-point interest rate cut last Wednesday afternoon, it was, in investment terms at least, already old news. With the economy visibly weakening since the start of the year, investors had been anticipating a rate cut for weeks, which is one of the reasons the Nasdaq posted one of its best January's ever and the Standard & Poor's 500 index shot up 7% from its early January low. The only real uncertainty was whether the Fed cut would be half-a-point or three-quarters, which helps explain why the markets reacted anticlimactically, falling on what should have been good news before heading still lower over the remainder of the week.
While some see this as confirmation of the old dictum, "buy on rumor and sell on news," when it comes to interest rate movements, there is a broader lesson to be learned: It doesn't pay to fight the Fed. Unlike the folks in those old Tarryton cigarette ads who proudly displayed black eyes and declared that they'd rather "fight than switch," when it comes to investing it may be better to switch than fight.
And we mean switch quite literally.
Call it the lazy man's guide to timing the market. Rather than concern yourself with elaborate charts and arcane theories, all you really need to do is to watch the Fed and put your money into stocks when rates start falling, then go to cash when they rise again.
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As the chart shows, the strategy has worked pretty well historically -- though not as well lately as it once did.
To test our thesis, we asked Tim Hayes of Ned Davis Research to compare the gains from buying and holding stocks over the past 21 years versus the rewards from switching back and forth between cash and stocks, depending on the Fed's actions. Hayes used the S&P 500 as a proxy for the market and the rates on commercial paper as a proxy for money-market rates. And to pinpoint rate moves, he used the key changes in the federal funds target rate since 1989, and changes in the discount rate prior to that.
From a starting point of January 2, 1980, $10,000 invested in the S&P 500 index would have grown to $128,357 on January 24. That works out to an average annual return of 12.9%. Over the same period, $10,000 assigned to an in-and-out switch strategy would have grown to $149,122, for an average annual gain of 13.7%. In other words, that eight-tenths of a percentage point difference, compounded over 21 years, would have added an extra 17.5% to your gain. (It should be noted that our numbers don't factor in taxes, which would be irrelevant in an IRA or 401(k), or expenses, which would have cut about one-fifth of a percentage point a year from the gains on an S&P 500 index fund.)
Most of those extra profits, however, came before the bull market went into overdrive. For example, from the start of 1980 through Fed tightening on February 4, 1994, a switch portfolio would have posted a 515% cumulative gain, compared to a 344% gain for a buy-and-hold approach. Indeed, that period accounts for more than 80% of the strategy's edge, or $17,055 of the $20,765 spread between the two.
How come? For one thing, interest-rate levels and interest-rate changes simply don't move markets the way they did in the Seventies and Eighties, when hordes of Wall Street types spent man-years trying to decipher what the Fed was up to and legions of investors hung on every pronouncement from Fed watchers, like Albert Wojnilower of First Boston and Salomon Brothers' Henry Kaufman, then known as Drs. Gloom and Doom. In addition, money-market rates in the early Eighties, when you would have sat out a chunk of the market, were far higher than they are today.
That said, Fed interest-rate changes still weigh on the market's direction. For example, the Fed's July 6, 1995 cut would have gotten you into the market in time to catch a 42% gain, though cashing out on March 25, 1997, would have meant you missed the 33% gain over the next 18 months.
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And while being out of the stocks between June 30, 1999, and January 2 of this year would have meant you missed part of the moonshot market, you'd have also missed out on the subsequent fall. (Overall, you'd have posted a $12,986 gain over that period, compared to a $2,378 loss for the folks who had simply held on.)
While the long-term advantage of switching isn't "dramatic, it's still respectable," says Hayes. "In 13 out of 13 calls going back to 1980 -- six buys and seven sells -- you never lose."
A still better tactic, he adds, can be to act not
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on the first rate change but the second.
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Jim Bianco, president of Bianco Research, agrees. "The first rate change is the Fed waking up to new economic conditions, for better or worse," he says. "When the second comes around, a Fed rate cut can help create a market bottom or a rate rise can signal a market top.
"In fact, whenever the Fed aggressively moves to cut rates, as it is now doing, it eventually works to boost the economy and stock prices. The opposite is also true in that when the Fed moves aggressively to raise rates, it dampens the economy and removes steam from the stock market."
But, you have to have faith in the strategy, warns Bianco. "Along the way, it often looks as if you have missed opportunities. |
