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'Don't fight the Fed': Conventional wisdom
holds
Heydon Traub, Boston Business
Journal, December 20, 2002
Over the last few years, we have discussed how important the Federal Reserve
Bank is to the economy and markets. The Fed controls short-term rates to a
large extent through its operations with banks as well as its purchases and
sales of treasury notes and bonds. There is a saying in the investment
business, "don't fight the Fed." What this means is that when the Fed is
raising rates, you want to be reducing your stock market investments and
when the Fed is cutting rates, you should be increasing your stockholdings.
In 2000, we discussed how the many rate hikes that began in 1999 were likely
to depress economic growth as well as the stock market. Well, that turned
out to be true in a big way. However, by 2001, the Fed began a long stretch
of cutting rates. Historically, this normally would have signaled an
improvement in the economy and markets. It did eventually lead to improved
economic growth as the recession in 2001 was mild and real economic growth
this year will likely be moderately good at just under 3 percent. However,
anyone who bought stocks when the Fed began to cut rates has lost a good
amount of money with the market falling 12 percent in 2001 and another 20
percent so far this year.
So some experts have concluded that the Fed has lost its touch. However,
keep in mind that the Fed's mission has little to do with the stock market.
The Fed's goals are threefold, and you won't see the stock market in any of
them.
The three goals are: 1) price stability, 2) a high and stable rate of
employment, and 3) acceptable growth in economic output. By cutting rates so
dramatically since the start of 2001, from 6.5 percent to 1.25 percent, the
Fed has managed to still keep inflation low and almost certainly improved
the employment and growth picture relative to the scenario where rates were
not cut.
In terms of the disappointing equity market, we believe this results more
from the extremely high level the equity markets reached by early 2000,
combined with a large decline in earnings that took place in 2001. Despite
the fact that the "don't fight the Fed" rule didn't pan out in recent times,
we don't believe the guidance is obsolete. Like most rules of thumb, they
don't always work. And although the "rule" didn't work recently, the
evidence is still in its favor.
We looked back in time to see how stocks and bonds have done in times when
the Fed was cutting rates (easing) and how they did when the Fed was raising
rates (tightening). Given that the most commonly used index for bonds is the
Lehman Aggregate, we used that index as a proxy for bond performance. Since
the index depicts return history back to 1979, that is when we began our
analysis. Since then, including the recent times where results "broke the
rule," the average monthly return of the market during easing was 1.33
percent vs. bond returns of 0.96 percent (we excluded months when the Fed
switched from easing to tightening or vice versa). A difference of 0.37
percent may not sound like much, but keep in mind that this is per month.
If you earned the above returns each month for a year, stocks would have
returned about 17 percent while bonds returned 8 percent. I think everyone
out there would be happy with 17 percent, and as importantly a spread of 9
percent vs. bonds per year is a large difference. Contrast that with results
when the Fed is tightening. Average monthly returns for stocks are 0.79
percent vs. 0.45 percent for bonds.
Again, putting into an annual perspective, the returns would be about 9.9
percent for stocks and 5.5 percent for bonds. Still good returns but
substantially lower for both asset classes and a substantially lower spread
between stocks and bonds.
Now to give full disclosure, along with ammunition to those who say the rule
no longer works, if you look at the last five or 10 years, the rule has not
worked as expected. However, as noted above, this really results from a very
small sample of observations in 2001 and 2002. If you look at the 10 years
ending in 2000, the rule still worked quite well.
In addition, we are now operating with vastly improved valuations compared
to the start of 2001. Based on expected earnings for 2003, the market trades
at a price-to-earnings multiple of 17, down from a peak of about 25 when the
bubble began to burst. Although the market is not exceptionally cheap, the
short-term outlook is favorable for stocks compared to cash or bonds as both
short- and long-term rates are near historic lows.
The low rates make stocks an appealing alternative. Think of it this way, if
you own a money market fund, you should expect to lose about 1 percent per
year in real terms, meaning after adjusting for inflation. And with treasury
bond yields back around 4 percent, real returns on bonds are only about 2
percent. The Fed has made it clear, it is not worried about inflation at the
moment and it will take all measures to avoid deflation. Given that, there
is a good chance of a pickup in inflation from the current 2 percent level.
If that happens, bonds will sink and the place to be will likely be stocks.
The rule isn't dead: Don't fight the Fed!
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