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Easing into profit

Created:

2 June 2008

Written by:

Simon Thompson

"Don't fight the Fed" is one of Wall Street's famous mantras. The theory goes that stocks do well during interest rate cutting cycles and less so when interest rates are on the rise. Coupled with this is the fact that The Federal Reserve is charged with keeping a watch over both economic growth and monetary conditions, making many investors believe that the US central bank has great power over the stock market. With this thought in mind, I have uncovered a potentially lucrative strategy to profit from the current rate-cutting cycle.

Fed cutting cycles

Let's consider how the S&P 500 index has performed in the past 13 interest rate cutting cycles over the past six decades. The start of the cycle is the date when the Fed funds rate is first cut, and the end of the cycle is when the period of monetary easing is deemed to have ended and is signalled by a rise in the Fed funds rate.

Since 1954, these monetary easing cycles have lasted 24 months, on average, and have been accompanied by an average rise in the S&P 500 of 33 per cent. However, as the average rise in the index is 15 per cent between the date of the first interest rate cut and final rate cut, then the best of the gains have actually been enjoyed in the period after the final rate cut to when the Fed starts to tighten monetary policy by raising rates. In fact, the S&P 500 has continued to rise after the final rate cut in all bar one of the past 13 rate-cutting cycles, posting an average gain of 15.7 per cent. The average period from the last cut to the start of the tightening cycle has been 12 months since 1954 (see table 1 below).

So a strategy of buying the S&P 500 once the Fed has signalled the end of monetary easing, and holding this position open until the first rate rise, has proved a passport to prosperity over the past six decades. Not only has the 15.7 per cent gain over the average 12-month period from the last rate cut been significantly above the long-term average return from the S&P 500, but the strategy has only failed to work once since 1954. Even then, in 1976-77, the loss was modest at 6 per cent. And remember, since 1980 this strategy has a 100 per cent track record with the index rising every time between the date of the last rate cut to when the Fed starts to raise rates.

But how do we know?

The key to this strategy is knowing when the Fed has made its last cut. Now clearly the Fed doesn't wave a flag to announce the fact, but there are some tell-tale signs: the minutes of each meeting and the futures market.

When the minutes of the Federal Open Market Committee (FOMC) April meeting were released on 23 May, it became apparent that the 25-basis-point rate cut had been a "close call" with "rising inflation risks weighing against growth concerns". As a result, the futures market now thinks the cutting cycle is over and is pricing in a 60:40 chance that rates will start to rise following the FOMC meeting on 28/29 October. If that materialises, then history tells us that the odds heavily suggest that at the end of October the S&P 500 will be trading above 1385, its closing level after the last rate cut in April.

In the meantime, we can afford to wait for the next meeting on 25 June, or if necessary until the full minutes of that meeting are released on 16 July, to get a clearer picture of whether the futures market is right in its assumption. And that wait could play into our hands, as it will give us time for the current down leg of this bear market to play out and, in particular, for the S&P 500 index to drop into my ideal buying zone of 1250-1300 (Presidential profits, 30 May 2008).

It's easy to understand why this 'buy-on-the-last-rate-cut' strategy works so well, as confirmation from the FOMC that the rate-cutting cycle has gone far enough is a sign that the US Central Bank believes the economic recovery is well on its way. In turn, this gives investors more confidence to start buying equities aggressively.

Remember, too, that monetary policy easing - the Fed has cut rates by 325 basis points since September 2007 - will have a positive and lagged impact on the economy as it takes time for the full benefits to feed through the system. Since the stock market is an efficient forward-looking discount mechanism, this explains why stocks generally bottom out between four to six months before US recessions end in anticipation of the upturn.

I think the futures market is being premature about a rate rise in October. Politically it would be insensitive, coming 10 days before the US presidential election. And by then the FOMC will have a clearer idea of the chances of the economic recovery stalling. In my opinion, the markets are still not factoring in the chances of a double dip. But, frankly, that will count for little if later this summer enough investors believe that the economic recovery has started, which would be reason enough for a pre-election rally on Wall Street.

In the circumstances, buying the S&P 500 index in the coming months looks a decent trade especially if we can enter our position significantly below 1385 and ideally south of 1300. So if you agree with the logic of this trade, one way of playing it is through Barclays iShares (TIDM: IUSA), an exchange-traded fund (ETF) that tracks the S&P 500.

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