One eye on your portfolio Featured

8:00pm EDT September 25, 2008

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 gjensen@niu.edu.