If you invest in the stock market, you
should pay close attention to Federal
Reserve actions.
“Investors need to consider Fed monetary policy to help guide investment decisions,” says Gerald Jensen, professor of
finance at Northern Illinois University and
an author of a number of studies that track
security returns and Fed policy decisions.
In a recent CFA Institute study, Jensen
and his co-authors showed substantial benefits associated with following a rotation
strategy predicated on Fed policy.
According to the study, when Federal policy is expansive, i.e. when the Fed is
decreasing rates, stock values generally
increase, while stocks tend to perform
poorly when the Fed is increasing rates (a
restrictive Fed policy). These patterns are
exaggerated for cyclical stocks, which creates the potential for investors to gain from
a sector rotation strategy.
Smart Business spoke with Jensen about
his research and its implications in the current market environment.
During the period of the study, how did stocks
perform when Fed policy was expansive versus restrictive?
Between 1973 and 2005, during expansive policy periods — that is, when the Fed
was lowering rates — the return averaged
17.4 percent. In contrast, during periods of
restrictive policy — returns averaged 5.3
percent. So, when the Fed was lowering
rates, stock returns were more than three
times higher than the returns earned when
the Fed was raising rates.
Has the relationship between Fed policy and
returns held true during the recent turbulence
in the financial markets?
The relationship has been surprisingly
consistent throughout history but has broken down considerably in recent months.
This can be attributed to several unforeseen developments. First, financial institutions greatly expanded the leverage of their
operations through the use of financial
instruments, such as collateralized debt
obligations (CDOs). Over the last few
years, these instruments experienced tremendous growth, which was then followed by a dramatic unwinding as credit
concerns caused investors to lose confidence in the instruments. The Fed’s effectiveness in influencing the financial markets was diminished by the rapid development and ultimate collapse of this market.
Second, after many years of increase, real
estate prices dropped substantially over
the last couple of years. Finally, commodity prices, and especially oil prices, experienced an unprecedented increase in the
last two years. These three factors combined to create a ‘perfect storm’ situation,
which has been devastating for the financial markets.
What future relationship do you project
between Fed policy and security returns?
U.S. financial markets are extremely
resilient, and I expect that markets will
resolve the problems that currently exist.
Some stabilization has already occurred.
Yet, it will take at least six months before
we completely recover from the extreme
shock that the markets faced over the last
several months. I believe we’ve hit bottom
and are on our way to recovery. I expect
that the effectiveness of Fed policy in impacting financial market activity will
gradually return to normal.
What does research suggest about investing
in precious metals and other commodities as
a hedge against all this instability?
People have always viewed precious metals, such as gold, as a good safety net during
periods of uncertainty. But precious metal
prices, like stock prices, have traditionally
exhibited a strong link with Fed policy.
Historically, the return on commodities,
in general, and precious metals in particular, has been poor when the Fed has been
decreasing interest rates. So despite the
fact that many people are feeling jittery and
want to put their money in a ‘safe’ investment, investors should be wary of increasing their allocation in commodities and
precious metals during the current period.
History suggests that the time to buy commodities, including precious metals is
when Fed policy is restrictive, that is when
the Fed is raising rates.
With the upcoming election, are there any
political factors that investors should take
into account?
People like to tie market performance and
politics together, but my recent research
reveals links that are surprising. A commonly held belief suggests that stocks do better
in periods of political gridlock. But our
research shows that the gridlock theory is a
myth, and market performance doesn’t differ significantly whether the government is
in gridlock or harmony (where all branches
are controlled by the same party).
We’ve also found that the third and fourth
year of a presidential cycle are traditionally
good years for investors. Why? It turns out
that Fed monetary policy provides a reasonable explanation. Specifically, Fed policy has historically been expansive in the
last years of a president’s term and restrictive at the start of the term. This pattern
prevailed during the most recent presidential cycle; however, the perfect storm scenario may have caused returns to deviate
from the normal pattern.
GERALD JENSEN is professor of finance at Northern Illinois University. Reach him at (815) 753-6399 or [email protected].
