Johnson et al., Invest with the Fed

On the back of a strong nonfarm payrolls number and a 5.5% unemployment rate U.S. markets sold off on Friday. Good news was once again bad news. The reasoning was that the Fed might start raising interest rates in June rather than September or even 2016 and that such an action would have a negative impact on stock prices.

Fed policies, especially since the financial crisis, have played a major role in shaping the trajectory of U.S., and even foreign, markets. Interest rates matter—a lot. They matter, as the authors (Robert R. Johnson, Gerald R. Jensen, and Luis Garcia-Feijoo) of Invest with the Fed: Maximizing Portfolio Performance by Following Federal Reserve Policy (McGraw-Hill, 2015) tell us in an appendix, in four key ways. First, they are critical inputs to asset valuation models. Second, they affect the level of business profits. Third, they affect the attractiveness of using margin to buy financial assets. And fourth, “there is a simple substitution effect that accompanies an interest rate increase as the attractiveness of newly issued securities (with higher promised payments) rises relative to the desirability of other securities.” (p. 277)

To invest with the Fed, it is helpful to know what equity classes have been the top performers in three monetary environments: expansive, indeterminate, and restrictive. Between 1966 and 2013, when the Fed was expansive the winners, with their mean annual percentage returns in parentheses, were small-value (44.04%), past performance losers (30.16%), apparel (28.45%), retail (27.03%), and autos (25.42%). When conditions were indeterminate the top performers were energy (15.35%), consumer goods (14.95%), financials (14.55%), food (14.39%), and average past performers (14.39%). Under restrictive conditions energy again topped the list at 11.47%, followed by consumer goods (8.36%), utilities (7.77%), food (7.00%), and steel products (6.93%). (p. 249)

The authors advocate (though perhaps “advocate” is too strong a word since they say that the strategy is not intended to be a definitive recommendation) an expanded rotation investment strategy, using five asset classes: equity classes, equity sectors, foreign country equities, real estate, fixed-income, and commodities. Investors who are anticipating restrictive monetary conditions and who believe that past is prologue might start looking at defensive stocks, mid-cap stocks, blend stocks, and past performance losers; energy, utilities, food, precious metal mining, consumer goods, financials; emerging markets, Scandinavian countries, Canada, BRIC countries; equity REITs, composite REITs; short-term T-bills; and a composite commodity index, industrial metals, energy, and agriculture. Those who believe that this time is different, at least in some respects, might want to make some substitutions in this list of past winners.

Invest with the Fed is, of course, far more than a set of performance tables. But as Fed “lift-off” nears, even though interest rates are expected to remain low for quite some time, investors would do well to review their portfolios. And to ratchet down their expectations. There’s a huge difference in returns between the top performers in expansive environments and the top performers in restrictive environments.