Investors advised to monitor Fed discount-rate decisions

Investors and financial advisers should take the Federal Reserve Board’s monetary policy into account when making portfolio allocation decisions, according to a new academic study. A sector rotation strategy guided by Fed rate changes could have substantially improved portfolio performance over a broad-market-index portfolio over the past 33 years, the study contends. “The results indicate that investors would be well served to modify sector exposures during different monetary-policy environments,” said Robert Johnson, managing director of the education division of the CFA Institute in Charlottesville, Va. He is one of four co-authors of the study, “Sector Rotation and Monetary Conditions,” which is slated for publication in The Journal of Investing early next year.
“Investors would have improved performance by placing greater emphasis on cyclical stocks during periods of Fed easing and overweighting defensive stocks during periods of Fed tightening,” Mr. Johnson said. Using the DataStream value-weighted market index, a broad-market index that he said is comparable to the Russell 3000, the study examines the relationship between equity prices and changes in the Fed discount rate between 1973 and 2005. “The indices were highly correlated,” Mr. Johnson said. “The market index returned 17.41% during periods of expansion [after the Fed lowered the discount rate] and only 5.34% during restrictive periods [after the Fed raised the discount rate].” Cyclical stocks did particularly well during expansive periods, Mr. Johnson added, returning an average of 20.27%, but fared poorly during restrictive periods, returning an average of just 2.25%. Non-cyclical stocks performed much better than cyclicals during restrictive periods, the study shows, returning 10.24%, but underperformed cyclicals during expansive periods, returning 14.65%. These results, Mr. Johnson argued, demonstrate that investors could improve their portfolio’s performance by “increasing exposure to cyclicals when the Fed eases and increasing exposure to non-cyclicals when the Fed tightens.” He stressed that the study shouldn’t be seen as a Holy Grail for investors and that the authors “aren’t advocating that individual investors make wholesale changes in portfolios when the Fed changes the direction of the discount rate.” But Mr. Johnson does advise investors and advisers to “monitor” Fed actions when making investment decisions, adding that advisers might use the results of the study to help manage clients’ expectations of portfolio results during different periods of Fed policy. The study appears to validate the old Wall Street adage “Don’t fight the Fed,” said Curt Weil, a certified financial planner and principal of The Lasecke Weil Wealth Advisory Group LLC in Palo Alto, Calif. But other financial professionals warn that the study may not be applicable to future portfolio performance. The study is “too simple,” said Robert Brusca, chief economist for New York-based Fact and Opinion Economics. “It assumes that the relationship among the key market rates is going to be the same in the future as it has been in the past.” In fact, Mr. Brusca argued, the study “does not reflect the new economy and the Fed’s changed behavior now that inflation is under control, and monetary policy is more sophisticated.” Complicating factors Leo Grohowski, chief investment officer for The Bank of New York Mellon’s wealth management division, also cautioned against using the study as “a reason to overweight and underweight sectors going forward.” For example, he said, value and cyclical stocks “have already done phenomenally well for so long that I would discount the extent to which they may outperform the market after another rate cut.” The study’s other co-authors are C. Mitchell Conover, associate professor of finance at the University of Richmond in Virginia; Gerald Jensen, professor of finance at Northern Illinois University in DeKalb; and Jeffrey Mercer, professor of finance at Texas Tech University in Lubbock.