This is a special guest post by Robert R. Johnson, Ph.D., CFA, CAIA . He is the President and CEO of The American College of Financial Services. The American College was founded in 1927 and has approximately 24,000 students enrolled in various programs. The College has provided professional education to more than 20% of the personal financial advisors, planners, insurance managers and wealth managers in the United States today. The blog post is based on his latest book – Invest with the Fed – published by McGraw-Hill and co-authored by Gerald Jensen of Northern Illinois University and Luis Garcia-Feijoo of Florida Atlantic University. He is also co-author of the books Investment Banking for Dummies and Strategic Value Investing: Practical Techniques of Leading Value Investors. Invest With the Fed shows how important Fed policy is to successfully implementing a value strategy.
Fed Policy and Value Investing
Lately the financial markets have been preoccupied with speculation on potential Federal Reserve Board actions. Given the current historically low level of market rates, the discussion is not focused on “if” but “when” the Fed will move to raise rates and what that will mean for the financial markets. Needless to say, “Fed Watching” has become a national obsession. Janet Yellen’s Congressional testimony has become, like House of Cards, must see TV.
But, what do investors want to see out of the Fed? Some market observers have suggested that rate increases are actually good news for investors because they signal that the economy is improving and no longer needs the rocket fuel of money supply increases to sustain economic growth. A perusal of the financial pages provides cases being made that financial markets actually outperform in a rising interest rate environment.
Conversely, investors are being inundated with articles that portend poor market performance in a higher interest rate environment. The case is made that rising interest rates increase the borrowing costs of companies and rising bond yields make bonds more attractive relative to stocks.
Which camp is correct? In a recently published McGraw-Hill book – Invest with the Fed – my co-authors, Gerald R. Jensen from Northern Illinois University, Luis-Garcia-Feijoo from Florida Atlantic University, and I, provide a comprehensive analysis of capital market performance across different Fed policy periods from 1966 to 2013. This book is a culmination of over 25 years of rigorous academic study of Fed policy and capital market returns. In it, we examine returns to different asset classes – stocks, bonds, hedge funds, alternative assets, and foreign equities – and also study returns to different equity styles (value, growth, and momentum).
One of our most interesting findings is that it isn’t so much the absolute level of interest rates that is related to security returns, but rather, the direction of interest rate changes that is important. We look at two key Fed policy rates – the discount window primary credit rate (commonly referred to as the Fed discount rate) and the federal funds rate. When both of these rates are rising we characterize the time period as a restrictive environment. When both rates are falling we characterize the time period as an expansive environment. When one rate is falling and the other rising, it is considered an indeterminate environment.
The evidence for stocks is pretty clear. The bottom line is that the stock market does very well in expansive monetary environments and performs relatively poorly in restrictive environments. The S&P 500 returned 15.18%, 11.10% and 5.89% in expansive, indeterminate, and restrictive monetary environments, respectively. Real returns to investors show even more dispersion as the inflation rate is significantly lower in expansive versus restrictive environments. Furthermore, these return differences are not attributable to higher volatility in expansive versus restrictive periods.
But, what about value investing? As a proxy for value we use price-to-sales (P/S) and, no surprise to the proponents of the value camp, confirmed a pronounced value premium over the time period from 1966 through 2013. Specifically, the quintile with the lowest P/S ratio had the highest return (14.8% annually) and the quintile with the highest P/S ratio had the lowest return (8.6% annually). Our evidence, however, expanded substantially on this general finding as we showed a dramatic difference in return between the lowest and highest quintile portfolios (sorted on P/S ratios) during expansive monetary environments and little difference in return during restrictive environments. In expansive environments, the low P/S ratio (value) quintile averaged a whopping 28.1% annual return, while the high P/S ratio (growth) quintile returned 13.8% — less than half that of the value quintile. Conversely, during restrictive periods the value premium was almost non-existent as the value quintile returned 5.0% and the growth quintile returned 4.1%. In essence, the value premium is almost exclusively limited to periods of expansive Fed monetary policy.
The bottom line is investors ignore Fed monetary policy actions at their peril. Fed policy matters a great deal to stock returns – and, rising interest rates aren’t good news for investors no matter how pundits try and spin it.
Invest with the Fed: Maximizing Portfolio Performance by Following Federal Reserve Policy by Robert R. Johnson, Gerald R. Jensen, Luis Garcia-Feijoo