Invest with the Fed
We recently spoke with Dr. Robert Johnson, co-author of Invest with the Fed: Maximizing Portfolio Performance by Following Federal Reserve Policy and president of the American College of Financial Services.
“I was a finance academic,” Johnson told me, explaining how the book came about. “I was also a money manager and a Fed watcher. I was convinced that the Fed has a tremendous influence on the financial markets. For context, this was in the late ’80s.
“It was before the fixation on Alan Greenspan uttering the term ‘irrational exuberance’ and having the markets collapse and so forth. This was before the Fed was front-page news. In fact, the Fed was barely in the financial news at that time. I was convinced that the Fed had a significant influence on capital market returns.”
As you’d expect a good academic to do, Johnson decided to study the Fed’s impact on investment returns in a rigorous fashion. He’s been doing that now for the last quarter of a century.
Invest With the Fed, he explained, is a “culmination of all of that research updated. I think the astute individual investor will get some tremendous insights about what the Fed’s influence on their returns is and how they can monitor Fed actions to hopefully increase portfolio returns or reduce their risk.”
Read on for our conversation…
Peter Coyne: Bob, welcome to The Daily Reckoning.
Bob Johnson: Thanks for having me.
Peter Coyne: Let’s jump right in. To telescope the premise of your book, Invest with the Fed: You look at the correlations between Fed policy and returns by asset class from 1966-2013. Based on your findings, you recommend a set investment strategy based entirely on what the Fed does.
To start, can you explain the three different periods of Fed policy that you say investors should focus on in order to use this strategy?
Bob Johnson: Sure, you can think about Fed policy in three different periods.
When interest rates are rising we call that a restrictive period. When interest rates are falling it’s an expansive period. And when interest rates are going sideways is an indeterminate period.
You know what period you’re in by looking at two interest rates influenced by the Fed — the Federal Reserve discount rate, which largely signals a long-term, broad monetary policy stance. — and the federal funds rate.
The Fed doesn’t change the discount rate very often. But if the last change in the discount rate was a decrease, you would say that the discount rate signals an expansive monetary policy. You should always look the last change the Fed made.
The second rate we look at is what’s called the monthly federal funds rate. Now the Fed sets a target fed funds rate, but what we look at is the actual fed funds rate in the market and we look at what the monthly average was. If the monthly average is declining, you would say that monetary policy is expansive. So we look at the direction of those two rates in the book.
If both rates are going down, we say it’s an expansive monetary policy.
If both those rates are going up, it’s a restrictive monetary policy.
The Fed has been expansive, restrictive, and indeterminate about the same amount of time from 1966 to 2013…
If they’re going in opposite directions, say the last change in the discount rate, for instance, was an increase and the last change in the fed funds rate was a decrease, we say that’s an indeterminate period.
What we’ve found is interesting. The Fed has been expansive, restrictive, and indeterminate about the same amount of time from 1966 to 2013.
In other words, the results that we look at aren’t driven by a small data sample, and that’s a really nice thing when you’re looking at statistics.
If, for instance, they were only restrictive or expansive for, say, a sixth of the time, the findings wouldn’t be that robust. But when there’s equal sample sizes, a third, a third, and a third, we think that you can draw some conclusions from that.
Peter Coyne: Let’s get into those. What are the conclusions investors should draw from your research?
Bob Johnson: I think the biggest conclusion that your readers can draw is, there are many pundits out there that are suggesting that if the Fed raises rates, it might signal good news to the markets because as the logic goes, that shows that the Fed has faith in the economic recovery.
That’s not what the evidence shows in the past.
What we find is that, on average, returns in the equity markets are much greater when the Fed is in an expansive monetary policy than in a restrictive monetary policy.
Peter Coyne: Right. Here are the returns by asset classes in the different periods for readers to look at.
In a few minutes we’ll explore one way readers can invest in each sector.
First, the top performing asset classes in expansive monetary conditions:
Second, the top performing asset classes in restrictive monetary conditions:
And finally, the top performing asset classes in indeterminate monetary conditions:
Bob Johnson: Exactly.
Peter Coyne: Should investors be concerned with what the interest rate is in evaluating these?
Bob Johnson: Our research shows is it’s not the level of interest rates that’s the most important factor, it’s the direction of interest rates.
Right now interest rates are at unprecedented low levels. Some people would say, “Well, wait a minute. Is it really a big deal if the Fed increases interest rates from unprecedented low levels and just slightly increases them?”
Well, what we find is that the relationship has to do with the direction of interest rates and not the levels.
Peter Coyne: What’s the causation there?
Bob Johnson: Well, during an expansive monetary policy, interest rates are falling. If you think about it, cash flows are worth more when rates are declining. That’s one theoretical link, if you will.
Another is the fact that if, for instance, in the recent time period, the Fed is infusing liquidity into the markets, people have more disposable income to spend. That should translate into higher corporate profits and so forth. I think it makes intuitive sense.
People lose the forest for the trees listening to Fed language…
You said causal effect, so I want to make the following point because I’m a little bit hesitant certainly to be quoted that the Fed causes these returns.
The Fed is reacting to the economy and the Fed influences the economy. But you don’t know what the direction is. I always say it’s correlation, not causality. If I’m an investor, I really don’t care what the cause is.
A strong case can be made that the Fed has a substantial influence on the economy and capital markets. I don’t think anybody’s going to argue with that.
But it’s the direction that important. Is the Fed leading or are they lagging in some cases? Well, the Fed is both creating and reacting. That’s why the Fed’s afraid to raise interest rates, because they may forestall the economic recovery.
Peter Coyne: Though you recommend investors react to the Fed’s policy announcements it seems that today the Fed’s “forward guidance” — Janet Yellen talking about what policy announcement the Fed might make in the future — is the new policy announcement. Does this dynamic change your advice?
Bob Johnson: I’m glad you brought this up at this point in the interview. Of course we’re interested in short-term reactions to the Fed policy changes. But we’re not as interested in them as we are in long-term returns.
I grew up in Omaha, Nebraska. I’m highly influenced by Warren Buffett. I’m a long-term investor. We were concerned with what Fed policy means for the investor in the book, not for the speculator.
People lose the forest for the trees listening to Fed language. I think that many people are focused on the timing of the Fed announcement and what that means for the markets in the near term. What our book looks at more is what it means for the markets long-term, and that’s what I think people need to focus on.
Peter Coyne: Given the constant coverage of the Fed in the press, do you think we’re in a new era of Fed policymaking?
Bob Johnson: Sir John Templeton once said the four most dangerous words in investing are, “This time it’s different.” I believe that.
I am hesitant to say it’s a new paradigm. I think there have been very few new paradigms. I remember back in 1999 people would say, “Oh, you can’t value Internet stocks using discounted cash flow analysis.” Well, it turns out you could. So, no, I don’t believe we’re in a new time period.
Now, could rates stay low for a long period? Could it be for an unusually long period of time? Sure. But do I believe that we are in an unprecedented era where rates are going to remain low for the foreseeable future? I don’t think so.
Peter Coyne: Let’s bring it back to the findings of the book then. What are some more lessons readers can take away?
Bob Johnson: It’s much easier to find really good-performing asset classes in expansive monetary conditions than it is in restrictive monetary conditions. Just across the board, it’s easier to find good performers.
There are a lot of investors who have developed their own investment styles. One example is what’s called “the small firm effect.” That idea is that small firms over time do better than large firms.
It’s much easier to find really good-performing asset classes in expansive monetary conditions…
Other investors might operate on the premise that value stocks will perform better than growth stocks.
What we found is the small firm effect is highly concentrated in expansive monetary policy periods, and the value effect is highly concentrated in expansive monetary policy periods.
That is there isn’t much of a small firm effect or a value effect in indeterminate and restrictive conditions.
So if you’re a value investor or you’re a small-stock investor, you get the bang for your buck in expansive monetary conditions, and that style doesn’t outperform in indeterminate or restrictive conditions.
The interesting thing to me is you see which equity sectors perform. It makes sense in expansive periods, there’s a wealth effect that people feel. Retail, apparel, autos, durable goods, those kinds of firms outperform.
If you look at restrictive conditions, the equity sectors that better perform are your traditional defensive sectors: energy, utility, food. So there is some intuition here, too.
Peter Coyne: For the beginner investor who looks at the tables above, should they simply find exchange traded funds (ETFs) to invest in?
Bob Johnson: Absolutely. In fact, we say in the book that the advent of ETFs — and investors can find an ETF that virtually follows any sector or any style — that if you want to utilize the information in the book and invest along with the Fed that one of the easiest ways to do that and cost-efficient ways to do that is to use ETFs.
Peter Coyne: What’s the one commonly held misconception among investors that your book dispels?
Bob Johnson: One thing that people may glean from the book is that the asset class that moved exactly opposite to equities during different Fed monetary policy periods were commodities.
Investing in a broad basket of commodities as rates are rising would have provided you with substantial returns over the equity markets. So the time to increase your commodity exposure is when interest rates are rising.
As far as a surprising finding goes, I was surprised that physical gold — commonly thought of as a good hedge against inflation — didn’t provide you with that protection. Gold futures actually did worse in restrictive environments than they did in expansive environments.
Inflation was much higher in restrictive monetary periods than expansive monetary periods…
On that topic, inflation was much higher in restrictive monetary periods than expansive monetary periods.
The S&P returned about 12.5% during expansive conditions. It roughly returned less than 7% during indeterminate periods. And it returned less a percent during restrictive conditions. So when you factor inflation in and look at real returns, there’s even a greater difference across the monetary environments.
Yet, if you look at the return to gold futures, subtract out the inflation rate and the return to gold futures in restrictive monetary conditions is negative.
By the way, people might look at the book as say “Well, this didn’t hold true in this period.” We get that. These findings are what happened on average.
There are some expansive conditions that were poor for stocks. There are some restrictive conditions that were wonderful for stocks. It’s on average.
Peter Coyne: Why then, given the returns you report, do you think many concerned investors still buy physical gold?
Bob Johnson: I think it’s that people have confirmation bias. People look for news sources to confirm what they already think. It’s the old Anchorman line, where Will Ferrell says: “Why should we tell ’em the news? Why not just tell ’em what they want to hear?”
I think that that’s what people look at with gold.
There are time periods that you can point to that holding physical gold was a very good investment, and so people will anchor themselves in that time period.
It’s behavioral finance. I think that’s a real danger for gold investors is that there is confirmation bias. They’re oftentimes listening to folks who are champions of investing in gold.
I would invest in precious metal miners and mining companies rather than the physical precious metal…
My bias has always been if you want to invest in precious metals, I would invest in precious metal miners and mining companies rather than the physical precious metal or precious metal futures.
That’s based on the evidence and based on the fact that there’s an equity market component to precious metals miners. Over the long run, that equity component doesn’t detract from results.
Oh, by the way, what I would say to your readers is all three of us, the authors of this book, do not believe that you should make wholesale portfolio changes based on the evidence. That is, you shouldn’t sell your entire equity stake off when the Fed starts raising rates.
We believe you can tilt your asset allocations instead. Within, for instance, equities, you can move from some equities that perform better in rising-interest rate environments.
I’m a golfer, and there was a famous golf instructor named Harvey Penick. He was Ben Crenshaw’s golf pro, and he would tell people he gave golf lessons to, “Take an aspirin. Don’t take the whole bottle.”
I would encourage your readers to glean some insights from the book. But I wouldn’t manage my entire portfolio that way.
Peter Coyne: Great, thanks for your time today, Bob.
The book is called Invest With the Fed: Maximizing Portfolio Performance by Following Federal Reserve Policy. There’s a lot more inside it that we didn’t cover here.
You can grab a copy on Amazon, and we recommend you do. Even the beginner investor will find explanations of how the Fed operates and of basic financial terms helpful.
P.S. “Three takeaways” writes one reader who bought Invest with the Fed on Amazon and gave it five stars. “First, the authors show that monetary policies dramatically effect overall investment performance, as well as various strategies. Second they explain and show the empirical results across asset categories and many styles and strategies. Dozens of ideas are carefully compared. Finally, the book is designed for a normal investor, not a sophisticated and experienced expert. However, because the book is so well organized and thorough, both a novice and an expert will enjoy it. Great read!”
We’ve also read through a copy. Beyond well-researched investment conclusions, it’s also good reference for how the Fed works and some easy to understand financial explanations. Click here to grab your copy now.