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Affluent Investor | June 24, 2017

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Waiting Until The Fed Panics

United States Federal Reserve (Photo by William Warby) (CC BY) (Resized/Cropped)

United States Federal Reserve
(Photo by William Warby) (CC BY) (Resized/Cropped)

Let’s say you’re on a boat with a clueless captain. Perhaps, like Ben Bernanke, he’s a former economics professor. The question is: Do you still worry when a clueless captain worries?

Well, yes. It’s prudent to worry even when a lousy captain worries.

On the other hand, are you confident when a lousy captain’s confident? Here you’d probably want to pause a bit.

The answer’s no different with the Federal Reserve. The question is how to act when the Fed’s worried and how to act when they relax. And since 1950 this pattern has held: sell when the Fed’s worried, but take your time after they sound the all-clear.

Looking at the data from our most recent crisis, this rule almost perfectly times your returns: selling when the Fed started cutting would have gotten you out at the top, and putting a several-month delay on the re-buy would have almost perfectly timed the bottom. Most important, this pattern holds since at least 1950.

First, let’s run through why the Fed changes rates. Central banks have an institutional bias towards too-low rates, since easy money is always popular. This easy money sets off a “tissue fire” that sparks inflation, then the Fed “cools off” the economy by raising rates. Thus the Fed lurches between too-low and too-high rates.

A gradual raising of rates suggests that the Fed thinks growth is healthy enough that it can “take back” some slack lest inflation come along. But at some point these risks — recession vs inflation — will seem balanced to the Fed and it will, like a deer in the headlights, freeze.

This freeze will look like a plateau on a graph, and it’s a signal to investors to start paying attention: if the next move is down, it means the Fed thinks that recession odds are jumping. And it’s not a terrible idea to take them at their word.

S&P vs EFF 2007Let’s run this on the real world. Here’s a chart of the Effective Federal Funds Rate and the S&P going into our latest crisis, 2008. You can see the ramp-up starting in June, 2004. And then the plateau, starting mid-2006. This plateau was the flag.

The next move, it turns out, was enormously informative: the Fed dropped their Target Federal Funds Rate on August 17 of 2007. As an investor, if you’d sold out the next trading morning, you’d have sold at 1,446 on the S&P, very nearly the top. You’d have completely missed the following collapse in stocks, which ultimately fell to the 700’s.

Not bad.

Keep in mind we’re not even getting into the performance of whatever you’d sold into — gold, say, or bonds. That compounds the win.

It gets better, though. The next bit of interesting geography on this chart is when the Fed finally did stop lowering rates for good: December, 2008. That was, again, almost exactly the bottom of the market.

So you could have sold the morning after the first drop, sat all comfy sipping wine while stockbrokers leapt out windows. Then you’d buy back the morning after the Dec 16, 2008 meeting, at 887, riding the market right back up.

You’d nearly double your money and sleep well.

SYP vs EFF 2000Now, there’s a twist here, called May of 2008. On the chart above it’s that little red shelf in the middle of 2008 (easier to see on the longer chart below – smack dab in the 2008 shaded region). That’s when the Fed took a stab at halting rate cuts. If you’d gotten back in then, you’d have bought around 1,400 and ridden it down. You’d be in there with the suckers.

Why did the Fed screw up? My guess is the Fed thought 2008 was just a run-of-mill recession; they didn’t appreciate the financial system risk epitomized by Lehman. Meaning the Fed, wrongly, thought the worst was over by May.

The point here is that you want to account for Fed error. This is easy, though: just wait a few months.

So don’t buy back in at the first leveling off in the Effective Funds Rate, rather wait for confirmation. Waiting for a few more meetings – something like 6 months — before buying back in gives you get a lot more security on the trend.

Running a 6-month delay on the 2008 crisis would have you buying back in around mid-May, 2009, at around 900. Almost as good as buying back in at the absolute bottom in March, 2009. Again, you’d have nearly doubled your money.

Back to the 50'sZooming out, this pattern of selling out when the Fed’s plateau breaks has performed well going back at least 60 years — here’s a chart going back to the 1950’s. Note the dives in Fed fund rates almost always signal imminent recession.

Stepping back, riding business cycles means having good indicators. But you want an indicator that’s not so early you miss out on too much market action in the run-up. Breaking plateaus do a great job of this.

So what does this indicator tell us about today? Taken on its face, it tells us we’re not even through mid-cycle yet. Historically, the party doesn’t even start until the Fed’s hiking rates, and the tiniest of hikes is barely on the horizon as of today.

I think the main caveat here is whether some “new normal” means that we are actually sitting on a plateau. If so, you’d want to keep an eye out for that cousin of rate cuts, Quantitative Easing (QE) — in particular for a dramatic up-scaling of QE. QE is similar to rate cuts because both are easy money, giving us the tissue fire the Fed loves.

What to look out for, then, is either a proper plateau-break on rates — which at this point would have to be significantly negative interest rates — or a dramatic up-scaling of QE. Either would serve as a fairly strong sell indicator.

 

Originally posted on Profits of Chaos.

Professor St. Onge holds a Ph.D. in Economics from George Mason University, a B.A. in Economics and Political Science from McGill University, and is Series 65 licensed. He teaches business cycle analysis and strategy, edits the Austrian Investment Monthly newsletter, and is a former Mises Institute Fellow. He managed funds for a decade, across both the dot-com cycle and the 2008 Crisis. He lives online at Profits of Chaos.

 

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