In the introduction to their 2015 book entitled Invest with the Fed: Maximizing Portfolio Performance by Following Federal Reserve Policy, authors Robert Johnson, Gerald Jensen and Luis Garcia-Feijoo state: “Our purpose in writing this book is to provide a general overview of the Fed’s role in the financial markets, but, more important, to offer investors a road map that can be used in designing an investment portfolio that takes account of Fed policy. In detailing our road map for investors, we offer a rationale for each investment strategy along with empirical evidence supporting the efficacy of the strategy. Most important, the recommended strategies come with clear explanations and easy-to-follow descriptions of the processes needed to execute the strategies.” The essential Fed policy discriminator they use is whether monetary conditions are expansive (decreasing discount rate and decreasing federal funds rate), restrictive (increasing discount rate and increasing federal funds rate) or indeterminate (one rate increasing and the other decreasing). Based on their research, they conclude that:
From Chapter 1, “Fed Monetary Policy and the Performance of Traditional Asset Classes” (Page 44): “For stocks and fixed-income securities, the real returns are prominent under expansive conditions and negative or negligible during restrictive conditions. Thus, historically investors have made substantial gains in purchasing power when the Fed has been in easy policy mode. In contrast, investor well-being has languished when the Fed has maintained a tight policy.”
From Chapter 2, “Monetary Conditions and Style Investing” (Pages 59, 70, 74): “…small stocks perform incredibly well during expansive periods. In marked contrast, small stocks perform remarkably poorly during periods of restrictive policy. …a strategy that targeted value firms during expansive monetary periods paid off handsomely whereas targeting value firms during indeterminate and restrictive periods was an awful approach. During indeterminate and restrictive periods, the best strategy would have been to target moderate price-to-sales firms… monetary conditions dictate which of the style strategies is superior and which is inferior.”
From Chapter 3, “Style Investing Extensions” (Pages 95-96): “…a strategy of targeting out-of-favor stocks (Losers) has paid off handsomely over the long run. More important,…the success of the strategy is largely dependent on the monetary environment. During expansive monetary conditions, targeting out-of-favor stocks has been a phenomenal strategy… In contrast, the strategy gets a rating of mediocre at best when monetary conditions are indeterminate or restrictive.”
From Chapter 4, “Monetary Conditions and Alternative Assets” (Page 127): “…an optimal investment strategy would maintain a fixed allocation to precious metals over time while adjusting (based on Fed policy changes) the relative proportion of the portfolio directed toward equities, real estate, and commodities. When Fed policy is expansive, overweighting equities and mortgage REITs is prudent, whereas periods of restrictive or indeterminate policy promote a strategy that overweights equity REITs and commodities.”
From Chapter 5, “Sector Rotation and Monetary Conditions” (Page 160): “…sectors that rely most heavily on discretionary spending (e.g., autos, durables, business equipment, retail, and construction) prosper when monetary conditions are expansive and languish when monetary conditions are restrictive. In contrast,…sectors that are less sensitive to disposable income levels (e.g., consumer goods, food, utilities, and energy) perform fairly well whether monetary conditions are expansive, indeterminate or restrictive.”
From Chapter 6, “International Stocks” (Pages 190-191): “The good news is that…emerging markets and the Scandinavian countries perform admirably when monetary conditions are either indeterminate or restrictive. …The bad news is that the return patterns we observed for the U.S. stock market prevail for the vast majority of foreign developed stock markets. Thus, most of the developed markets offer little relief from the dismal performance…under restrictive monetary conditions.”
From Chapter 7, “Hedge Funds” (Page 220): “…the success of these [long-short equity] strategies depends almost exclusively on the monetary environment. Specifically, when Fed policy is expansive, the performance of these strategies is exceptional, but the strategies perform poorly when Fed policy is indeterminate or restrictive.”
From Chapter 8, “Fixed-Income Securities” (Page 244): “…fixed-income investors should target high-yield bonds when monetary conditions are expansive and target long-term bonds when conditions are indeterminate.”
From Chapter 9, “Investment Strategies” (Page 266): “…the performance of the expanded [multi-class] rotation strategy is phenomenal. The strategy generates an annual [gross] return of approximately 20%… The strategy subjects investors to a moderate amount of additional risk.”
In summary, investors will likely find Invest with the Fed an academically well-researched and understandable analysis of interactions between Fed policy and asset class performance.
Cautions regarding conclusions include:
- As acknowledged in the book (Page 271), recommended asset rotation strategies designed to exploit monetary conditions:
- “…suffer from substantial hindsight bias. The securities included in the rotation strategies were selected after we observed their superior performance.” In other words, the strategy tests are in-sample, not out-of-sample, thereby overstating expectations.
- …do not include [considerable] transaction costs.” Arguments for mitigation, such as the current availability of low-cost and liquid exchange-traded funds do not address the counter that such availability will change the market.
- Testing of many strategies on the same set of Fed policy changes introduces snooping bias, such that the best-performing strategies likely overstate expectations.
- Sample periods may not be long in terms of number of changes in the three general monetary conditions (expansive, restrictive, indeterminate).
- The influence of the Fed, especially on a global scale, may vary with U.S. economic fortunes.
