Kathy Valentine
+1 (434) 951-5348
kathy.valentine@cfainstitute.org
Jessica Galehouse
+1 (434) 951-5376
jessica.galehouse@cfainstitute.org
New Study Suggests Investors Should Consider Fed Policy in Trading Decisions
Results show a pronounced and persistent improvement in portfolio performance from using Fed policy to guide investing
Charlottesville, Va., September 4, 2007 − In a recently completed study, the authors of many widely-acclaimed articles on Federal Reserve policy and security returns show that Fed rate changes are associated with strong patterns in equity returns.
The results from “Sector Rotation and Monetary Conditions” (PDF), which will be published in a forthcoming issue of the Journal of Investing, indicate that a sector rotation strategy guided by Fed rate changes could have substantially improved portfolio performance over the past 33 years. According to the rotation strategy, a more aggressive posture is advocated following decreases in the Fed discount rate and a more defensive posture is recommended following a rate increase. On the heels of the recent Federal Reserve discount rate cut, this timely study seeks to provide some direction to investors.
The co-authors of this study are Robert Johnson, Ph.D, CFA., managing director of the CFA Institute Education department; C. Mitchell Conover, Ph.D, CFA, associate professor of finance at the University of Richmond School of Business; Gerald R. Jensen, Ph.D., CFA, professor of finance at Northern Illinois University College of Business; and Jeffrey M. Mercer, Ph.D., associate professor at the Texas Tech University College of Business. (View "Political Gridlock Creates Lower Stock Returns, Higher Bond Returns According To Study "Gridlock's Gone, Now What?" and “The Presidential Term: Is the Third Year the Charm?”)
The authors consider long-term stock returns following directional changes in the Federal Reserve discount rate. They identify a prominent pattern whereby stocks generally languish during periods following discount rate increases and prosper during periods following rate decreases. Consistent with expectations, the authors find that the return patterns deviate considerably across sectors. Specifically, relative to defensive stocks, cyclical stocks exhibit far more sensitivity to changes in monetary conditions. The results show that in general, using announced discount rate changes as indicators of when to shift a portfolio to a more aggressive or defensive posture would have allowed investors to significantly enhance portfolio performance. Specifically, performance is enhanced by shifting into cyclical stocks following rate decreases (a signal of more expansive monetary policy), while the appropriate response to a signal of a more restrictive Fed policy is a shift to defensive stocks.
The key empirical findings reported in the study include the following:
- Between 1973 and 2005, returns for a market portfolio averaged 12.0 percent. The return was 17.4 percent in periods following discount rate decreases (expansive monetary policy periods) and 5.3% following rate increases (restrictive monetary policy periods). Thus, returns following discount rate decreases were three times the average return earned following rate increases.
- The average return for cyclical stocks (cyclical consumer goods, cyclical services, general industrials, information technology, financials, and basic industries) was 20.3 percent during expansive periods and 2.3 percent during restrictive periods.
- The average return for noncyclical stocks (resources, noncyclical consumer goods, noncyclical services and utilities) was 14.7 percent during expansive periods and 10.2 percent during restrictive periods.
- A sector rotation strategy guided by Fed policy shifts beat the benchmark portfolio by 3.5 percent per year.
- Federal Reserve policy shifts occur infrequently. In the 33-year study period, the Fed only changed the direction of the discount rate 14 times.
- In the 33-year study period, the Fed was expansive 57 percent of the time and restrictive the remaining 43 percent.
“As expected, short term market reactions to the recent discount rate cut were positive. The results of this study indicate that in the past this positive market performance has persisted over the long-term following rate decreases,” said Johnson. “Furthermore, the results indicate that investors would be well-served to modify sector exposures during different monetary policy environments. Specifically, investors would have improved performance by placing greater emphasis on cyclical stocks during periods of Fed easing and over-weighting defensive stocks during periods of Fed tightening. Our evidence confirms the view that effective portfolio strategies require investors to carefully monitor monetary policy developments.”
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