How Does Fed Policy Influence Financial Markets?
Everyone knows that Federal Reserve policy has an effect on security returns. But did you know that small value stocks returned nearly 40% more during periods of expansive monetary policy than during periods of restrictive policy? That’s the kind of data uncovered by three charterholders — Robert Johnson, CFA, Gerald Jensen, CFA, and Luis Garcia-Feijoo, CFA, CIPM — in research leading to their book Invest with the Fed, published in March 2015 by McGraw-Hill.
In this interview with CFA Institute Magazine, Johnson, president and CEO of the American College of Financial Services and former deputy CEO and senior managing director at CFA Institute, discusses the trio’s Fed research (covering the period from 1966 through 2013). Highlights include a foundational model for classifying Fed monetary periods, how monetary policy affects investment style and individual sector returns, and strategy recommendations for maximizing returns when Fed policy is expansive or restrictive.
Jaye: What was your impulse in writing this book?
Johnson: Well, it wasn’t an impulse. My co-authors and I, particularly Gerry Jensen, have been researching Fed policy and capital market returns for over a quarter of a century. The genesis was when I ran a private wealth management firm. I was convinced from my own experience that Fed policy had a major impact on market returns. Being the trained academic that I was, I wanted to systematically research that. Gerry and I were amazed at the results from the very start. We have made this area a major focus of our research and have published our findings in both academic and practitioner journals.
We’ve distilled our academic research into a format for the astute investor. This certainly isn’t a book aimed at the novice investor. This is aimed at the serious, shrewd investor — both individual and institutional.
What did you find about Fed policy and security returns?
We found a strong association between Federal Reserve monetary policy and asset returns across the spectrum of asset classes. It’s a very strong association, but we’re not saying that Fed actions cause these returns in the market, because obviously the Fed both influences the market and reacts to developments in the market.
How has the association held up over the period of your research?
It varies, and again, it isn’t a one-to-one correspondence. For instance, equity markets perform best in expansive Fed monetary periods. They perform less well in indeterminate monetary periods, and they perform the worst in restrictive periods. Now again, that’s on average. Just because the Fed is adopting an expansive stance, returns won’t necessarily be higher in every period. But on average, there’s a very strong association, and it’s been remarkably consistent across nearly 50 years.
How much should an investor’s portfolio consider Fed policy?
I think investors ignore Fed policy at their own peril. I believe it’s a factor that investors definitely should consider. And it should be one of the biggest factors they consider because of the strong association between Fed policy and security returns. You simply can’t ignore the wealth of evidence that we find in the book.
I think that most investors intuitively realize that there is a strong association between Fed actions and market returns. But most investors have not systematically examined it, nor do they realize the extent of the relationships. In other words, I don’t think it’s news that when Fed policy is expansive, markets have done better. I do think it is news to look at how pronounced the differences are and how pervasive the effects are across stock, bond, real estate, commodity, and global markets.
What are indicators of Fed policy?
We look at what the Fed does, rather than what the Fed says. If you look at the media, they are very focused on nuances in Fed language. For example, what could certain statements mean for future actions? We don’t pay attention to that. Additionally, it’s hard to analyze what the Fed is saying. If you’re trying to outguess what the Fed is going to do, that’s a loser’s game to me — a difficult one to win. So in the book, what we look at is what the Fed has actually done.
How do you classify Fed monetary policy?
We classify monetary policy in a very simple manner — in a manner that the lay investor can follow. Our scheme is not based on any judgment or intuition. It’s simply based on what’s happened to two interest rates. We look at the Fed discount rate, and we look at the monthly average federal funds rate (as opposed to the federal funds target rate).
The data on these rates are available on the Federal Reserve Bank of St. Louis website. To classify monetary policy, we look at the last directional change in each of these rates. What was the last directional change in the discount rate? What was the last directional change in the monthly federal funds rate? Our research has shown that it’s the direction of interest rates that is more highly associated with market returns, rather than the level of interest rates. Many investors are focused on the fact that interest rates are at historic lows. But what we found in the past is that, regardless of the level of interest rates, it’s the direction of interest rates that has a greater influence.
What are your three classifications?
Changes in the discount rate signal a broad Fed policy intention — what we call stance. Changes in the federal funds rate show Fed actions in the short-term market — what we call stringency. Combining these two indicators gives us three possible classifications of monetary policy: expansive, restrictive, or indeterminate.
If the Fed raises the discount rate, that signals a restrictive policy stance. If the market-determined federal fund rate rises, that signals greater constraint in the stringency of Fed policy in the market for short-term financing. When both factors signal tight policy, the monetary condition classification is restrictive.
On the other hand, if the Fed lowers the discount rate, that signals an expansive policy stance. And if the market-determined federal fund rate also falls, that reinforces the stringency of the Fed’s policy in the market for short-term financing. When the two factors combine to signal easy policy, we classify that as an expansive monetary period.
When the two rates are moving in different directions — say, the discount rate is decreasing while the federal funds rate is increasing, or vice versa — we term that an indeterminate monetary policy. Again, it doesn’t involve any judgment on the part of the investor. It’s just what it is. The point is that even a simple classification model can result in dramatically different returns. The reader of CFA Institute Magazine is likely to be a very sophisticated investor. If investors are able to improve on our basic classification model (for instance, correctly anticipating Fed moves) or modify our approach a little, they likely could capture much higher returns than we report in the book.
How should investors prepare for a policy shift?
Psychologically, investors should prepare themselves for lower returns in the equity markets when the Fed is restrictive and should expect higher returns on average when the Fed is expansive. It’s an element of behavioral finance that’s fueled by all the Fed watching that’s going on, this myopic media focus on the Fed.
Would we suggest that you pull out of equities and put all your money into commodities during restrictive environments (because we’ve found commodities perform very well in restrictive Fed environments)? Of course not. But you may want to tilt your asset allocations — that is, have a slightly higher equity exposure during expansive periods and a slightly higher commodities exposure during restrictive periods.
How does monetary policy affect investment style?
We found that monetary policy has a large influence on returns to the two most widely followed investment styles — size and value. The small-firm effect (that small stocks perform better than large stocks) is largely concentrated in expansive monetary environments. That is, small stocks don’t do very well in indeterminate and restrictive environments; however, small stocks do exceedingly well in expansive environments.
The same thing is true for the value effect. In the book, we present findings for one particular kind of value multiple, price-to-sales. You can look at other common value metrics — P/E and price-to-book, for instance — and the results are very similar. In the book, for purposes of exposition, we simply show price-to-sales. The price-to-sales effect is very pronounced in expansive environments (that is, firms with a low price-to-sales ratio perform well in expansive environments), and there isn’t much of a price-to-sales effect in restrictive environments.
Both the size and value effects are concentrated in expansive monetary environments. So if you’re an investor and you have a small-stock bias, expansive periods are when that small-stock bias really manifests itself.
Are investors aware of these effects?
I don’t think that even professional investors are fully aware of those effects. I certainly believe that amateur investors have little understanding of the return patterns. I believe most investors think that, in general, stocks do better in expansive periods and worse in restrictive periods. But I don’t believe that even professional investors understand the magnitude of the patterns. For instance, we document that small value firms returned 44% annually during expansive periods, as opposed to only 4.8% annually in restrictive periods. I don’t think investors realize the patterns are that pronounced.
How often is the Fed expansive?
The Fed has adopted an expansive, an indeterminate, and a restrictive monetary environment about a third of the time each. In other words, from January 1966 to December 2013, which is the length of time that the bulk of the research in the book covers, the Fed policy was expansive 172 months. Fed policy was in an indeterminate classification 209 months and was restrictive 195 months. There are 576 months in the sample overall, so the results aren’t driven by a small sample size.
What’s the effect of Fed policy on sectors?
There are some substantial differences in returns across stock market sectors. For instance, you find extremely high returns in retail, apparel, autos, and construction in expansive periods. And if you think about it, that makes sense. Those are the kinds of sectors that are going to be most affected by consumer discretionary spending. When are you going to buy a new car or suit or renovate your home? Those are likely to occur when you have more discretionary income. When times are tough, you might forgo these kinds of purchases.
So you find much lower returns in those same sectors during restrictive periods. Returns in the retail and apparel sectors in restrictive periods are 1.68% and 2.30% annually — incredibly low. The differences between returns in expansive and restrictive periods are dramatic in those sectors that are most reliant on consumers having disposable income.
Some sectors perform relatively well in restrictive time periods — utilities, for instance. Utilities have a 7.80% annual return in restrictive periods and a 9.36% return in expansive periods. This makes intuitive sense. People still need electricity when money is tighter. Now, they may use less electricity, or conserve a little bit, but they still use it.
In other words, it makes economic sense. The same holds for energy. Returns to the energy sector are about the same across expansive, indeterminate, and restrictive periods. People may not buy a new car, but they’re still going to drive their car and they are still going to heat their homes. It’s the same with food. The food sector performs pretty well in a restrictive environment. Defensive sectors tend to do pretty well in restrictive Fed monetary environments, and cyclical firms tend to do well in expansive environments and poorly in restrictive environments.
You found relationships on global investing that I hadn’t expected.
We hadn’t expected some of those either. There’s good news and bad news here for the domestic US investor. The bad news is that global financial markets tend to be very highly correlated. When the US markets are doing well, the world developed markets tend to do very well. So there isn’t a great deal of diversification from a return standpoint by investing in global equities during restrictive monetary periods.
The good news, however, is that you find the exact opposite pattern with emerging markets and particularly frontier markets (I would note that due to data constraints, the time period we utilized for emerging and frontier markets is shorter than the US sample). Emerging and frontier markets have tended to do better when the Fed is restrictive rather than when the Fed is expansive. It isn’t every time period, but in the past, on average, that’s the case.
What’s the reason for that?
I can’t give you a definitive reason. Our conjecture is that in the past the developed market central banks tended to have highly coordinated policies. That is, the developed markets tend to be more interrelated both economically and in terms of their central bank policies. Emerging and frontier markets are not so interrelated. They’re more independent. Also, many of the emerging and frontier markets are commodity based, and commodities tend to do well during restrictive monetary periods.
So look to developing markets in restrictive times?
Warren Buffett has been quoted as saying, “Be fearful when others are greedy, and be greedy when others are fearful.” Well, when the Fed is raising interest rates and people are fearful about the US markets, they translate that fear into developing markets. In other words, that’s the hardest time to sell somebody on the fact that the US market may not be a great place to be invested and the developing markets may be a better investment. People think, “Oh my gosh, I want to be more conservative and avoid emerging markets instead of taking a more aggressive approach.”
What did you find about Scandinavian countries?
The Scandinavian countries are a fascinating case study. Denmark, Norway, and Sweden had performance that was remarkably good across all US monetary policy periods. What makes them special? They certainly aren’t as integrated into the European Union. None of those countries use the euro as their currency. Each country exercises its own monetary policy independently and isn’t tied to the European Central Bank.
They also tend to have much less public debt as a percentage of GDP than many of the other developed markets, they’re not developing countries, and they have a very high savings rate. I think the Scandinavian countries’ performance looks pretty good and especially when other markets may not be performing well.
What about hedge funds?
You know, hedge fund data are notoriously dirty data. Only some funds report, and funds frequently go out of business. These issues create all kinds of biases in hedge fund numbers. What we did in the book was look at hedge fund strategies that involve taking long and short positions to capitalize on common trading strategies.
Our basic finding was that when Fed policy was expansive, the performance of hedge fund strategies tended to be exceptional, but the common hedge fund strategies performed poorly when Fed policy was indeterminate or restrictive.
Hedge funds are selling people on the fact that they could provide a reasonable return across all environments. What we find is that with respect to monetary policy, that’s simply not the case. The common hedge fund strategies perform very well during expansive Fed environments and perform poorly during restrictive environments, and there’s no good news in that.
What strategies do you recommend based on your research?
An astute investor should change his or her tactical asset allocation weightings based on Fed policy considerations. Again, I wouldn’t recommend completely moving out of stocks when the Fed is restrictive or completely moving into commodities when the Fed is restrictive. But I would recommend lessening stock allocations when the Fed is being restrictive and increasing commodity allocations.
Let’s say you’re 60% equities, 20% bonds, and 20% other alternatives, including commodities. Your equity exposure may go down to 40% during restrictive time periods. And I wouldn’t go to 100% when the Fed is expansive, but around the edges, I would make changes. In terms of asset classes, when the Fed is expansive, small value is very attractive as [are] past performance losers.
When the Fed is restrictive, energy and utilities, along with food, are the sectors that I would be focused on. So it isn’t just asset allocation changes I would make — it’s within the particular buckets. For example, the equity bucket may see a migration from small value stocks in expansive periods to a higher weight on energy and utilities during restrictive periods.
By the way, it’s much easier to do this now than it would have been in the past. Now an investor can use ETFs to effect these portfolio changes. There are ETFs that literally mirror all of these asset classes and sectors and many of the strategies that are discussed in the book.
Can you describe what you call expanded rotation?
There’s equity rotation and expanded rotation. Equity rotation is changing the mix within the equity bucket. Expanded rotation is about asset allocation changes — tactical asset allocation changes where you’re changing the size of the bucket. Or you may want to increase your equity exposure in total. You can make changes within the bucket and changes to the size of the bucket.
Will these effects continue to hold in the future?
People have asked me that question before. Do we think these patterns are going to continue through time? Unless people’s behaviors change through time, I don’t know why these patterns wouldn’t continue in the future. Will they be as pronounced as they have been in the past? Who knows? But directionally, I would expect them to continue.
One of the biggest reasons is that people’s behavior doesn’t change that much. From an individual investor’s standpoint, a lot of the behavioral finance biases that people exhibit are pretty constant through time, and I think that behavioral finance can drive some of these results. For those CFA charterholders who earned their designation many years ago, I believe it is worth your time to study the literature on behavioral finance.
Is it notable that all three authors are CFA charterholders?
There’s a real CFA flavor to this book. All three authors are CFA charterholders, as well as each having a PhD. I call myself a pracademic — that is, part practitioner and part academic. I never wanted to research anything to simply communicate with other academics. I always wanted to research relationships that practitioners are interested in. The reason for the book was that Gerry, Luis, and I all have that practitioner bias: we want to research things that people on the front lines, people out there investing, are concerned with.
We’re not necessarily interested in simply theoretical relationships but are interested in very practical relationships. The other thing is we’re all three very good friends, and it gave us a good excuse to work together.
Nathan Jaye, CFA, is a speaker on intelligence and member of CFA Society San Francisco. This article originally ran in the July/August 2015 issue of CFA Institute Magazine.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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