Market Timing with the Fed Fund Rate

Most market timing systems include a monetary component looking at the direction of interest rates. One of the main interest rate looked at is the Federal Reserve (the FED) Fund Rate.

Historically, the stock market has performed better when interest rates were dropping than when they were rising.

One issue with Monetary Market Timing systems is that they tend to be complex. If you’ve read Winning on Wall Street from Martin Zweig, you know what I mean.

Here is a simpler system that you can use.

Simple Monetary Market Timing system

Because it takes 6-12 months for interest rates to take effect, we will use a delayed signal by looking at the direction of the interest rates 12 months ago.

At around the 1st of January, check the direction of the Fed Fund Rate 12 months ago:
  • If Fed Fund Rate 12 months ago decreased vs 24 months ago, invest in Stocks and hold for 1 year,


Market Timing with decreasing Interest Rates

  • If Fed Fund Rate 12 months ago increased vs 24 months ago, stay on the side (or invest in Cash/Bonds) and hold for 1 year.


Market Timing with increasing Interest Rates

Then next year, start again. Isn't that simple ?

A major benefit of this system compared to other monetary market timing systems is that you just need to check it once a year. In addition, since holding period is 1 year, you can just extend this to “1 year + 1 day” to make it Tax friendly and not be subject to short term capital gains tax.


How this timing system fared ?

Here are the performances using the S&P500 Returns (Dividends excluded) from 1954 to 2008.

Fed Fund RateAverage ReturnStandard Deviation
Decreasing Rates11.7%17.8%
Increasing Rates5.3%17.0%

As you can see, despite its simplicity, the model does a good job at calling for favorable times to be in the stock market.

When interest rates are rising, you can find better alternative investments: Cash and Short term Bonds usually benefit from increasing interest rates !

Let’s try to improve this system by combining it with the Presidential cycle market timing system.

Combined Monetary and Presidential Cycle Market Timing

In Data Driven Investing, the authors combined the Fed actions and the Presidential Cycle.

  • Presidential cycle is split between early (years 1 and 2) and late (years 3 and 4) years.
  • Fed action is split between accommodating, aggressively accommodating, restrictive and aggressively restrictive.

    Best time to invest is in late years when the fed is aggressively accommodating while worse time is in early years when the fed is aggressively restrictive.

    This is confirmed with the following table that combines the above simple monetary model and the Presidential Cycle. The results use the S&P500 (Dividends excluded) from 1954 to 2008.

    Interest RatesElection YearAverage ReturnsStandard Deviation Positive Year Min ReturnMax Return
    Decreasing Rates115.4%17.6%80%-11.5%31.0%
    28.7%25.5%60%-23.4%44.2%
    317.7%10.2%100%2.0%31.4%
    44.3%19.5%86%-38.5%19.1%
    Decreasing Rates,
    All Years    		11.7%17.8%84.0%-38.5%44.2%
    Increasing Rates1-3.2%15.2%38%-17.4%27.3%
    22.5%20.6%56%-29.7%36.9%
    318.8%10.4%100%3.5%34.1%
    47.2%12.9%71%-10.1%25.8%
    Increasing Rates ,
    All Years    		5.3%17.0%63%-29.7%36.9%


    - Year 1 provides good returns if the Fed policy is accommodating (Decreasing Interest Rates).

    - Year 2 is very challenging (volatile) whatever the Fed policy.

    - Year 3 provides exceptional returns whatever the Fed policy.

    - Year 4 provides average returns whatever the Fed policy (Performances and Volatility with decreasing rates has been affected by the Bear Market in 2008)


    Monetary and Presidential Cycle Market Timing



    From those results, let’s define a Combined Monetary / Presidential Cycle Market Timing System:
    - Year 1: invest in stocks if interest rates were dropping 12 months ago
    - Year 2: stay on the side
    - Year 3: invest in stocks
    - Year 4: invest in stocks

    This system does a good job at capturing most of the returns (>90%) of a Buy and Hold strategy but at a much reduced risk. Using the S&P500 from 1950 to 2008 (excluding Dividends), the strategy earns an average return of 7.5% (standard deviation 12.9%) while Buy and Hold earns 8.4% (standard deviation 17.1%).

    It does not beat the combined Best 6 months and Presidential Cycle Market Timing in terms of Average Returns, however it has an amazing rate of positive years: you make money in 93% of the years versus only 70% for the combined Best 6 months and Presidential Cycle.

    Check this improved monetary and presidential timing system suggested by a reader.

    Finally, check Growth Stock Picking & Market Timing to improve your Growth Stock picks with lower risks thanks to timing with the fed fund rate.
    		•

    Go Back to Top