Fighting the Fed: What Does it Mean?

Investors eventually learn not to "fight the Fed."  The Fed has more power and a lot more money than you do.

It is popular in the investment punditry to criticize the Fed, blame the institution and the members for all problems, and claim that nearly anyone could do a better job than the incumbents.  It is great fun in the Will Rogers tradition, and very popular in the blogosphere.  The audience is heavily skewed toward Tea Parties.

Most of the popular bloggers and big-time pundits commenting on the Fed have been wrong at every point.  First they failed to predict what the Fed policy would be.  This is actually the most important thing for investing.  Having missed that boat, they then criticized the actual policies.  Finally, even though the policies seem to have stabilized the economy, they argue that we have "only delayed" the final result.  This Limbaughesque approach is only good for page views.

Instead, let us try to make money on our investments.

Fearless Forecasts

Sometimes I write an article that takes hours to develop and document, only to learn that few read it.  Let me take a different approach.  I offer some conclusions based upon extensive analysis, but I am not going to write it all down at this moment.  Here are the conclusions.  I will expand as circumstances and the situation warrant.

Background.  Fed Chair Bernanke, in written testimony (actual appearance snowed out) offered  some comments about how the Fed would gradually unwind the extraordinary policy measures employed over the last two years.  None of this should be a surprise.  In fact, many critics have clamored for some clarity.

With the snow on the east coast, some felt that today's trading was not meaningful.  The facts are that the market sold off by 0.5% or so on the statement and most journalists saw it as the negative news for the day.  Most media observers thought this was a big deal.

Conclusions.  In particular, how will a change in Fed policy affect stock prices?

  • Everyone knows this is coming.  Interest rates are at zero.  They can only move higher.
  • This signal is far in advance of the policy change.
  • The moves are intended to remove extraordinary accommodation.
  • This is not the same as "tightening."  We may be years away from a Fed policy that is actually restrictive.

Briefly put — some will mistakenly equate a return to normal interest rates as a bearish sign, a loss of stimulation.  In fact, it is a sign of economic recovery.

More Evidence

Three years ago I wrote an article that was one of my best — at least on my own scorecard.  It was not very popular, perhaps because it involves methodology and takes some work to follow.  You can check it out here.

The main point is that when interest rates are extremely low, the "Fed model" approach breaks down.  No one believes that an interest rate of 1% implies a stock P/E of 100.  When rates get too low, it is a sign of danger.

So here is the key takeaway —

As interest rates move higher, it is a sign of strength.  It will signal P/E multiple expansion.

That is not an opinion.  It is a conclusion based upon data.  There may be a negative, knee-jerk reaction, but increasing interest rates are actually a positive sign — at least until normal levels are reached.

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8 comments

  • Amber Guity February 10, 2010  

    Yes that has been my understanding or put this way PE ratios reflect demand for that issue- higher earnings momentum growth stocks average 45 PEs while big DOW s&p low ones but you make sense because at extreme low interest rates are also low since the economy is such there isnt even any demand for money to invest- in what there isnt a future whereas the PE expansions reflect confidence in future earnings are back in view.

  • Kevin February 11, 2010  

    Jeff – always enjoy reading your posts. I had an interesting experience last year: almost deleted your blog from my feed when your views opposed mine too strongly (I had a bearish outlook). I then recognized my confirmation bias and fortunately did not. Thank you.
    Kevin

  • Dal February 11, 2010  

    Once again, Jeff, the rational approach is proven to be the most obvious, yet the most easily forgotten. Thanks for the reminder about interest rates. If ever we had a ton of time to bake in expectations for rising interest rates, it’s now.
    from yourpaldal

  • Greg Pribyl February 11, 2010  

    Your post conflates two interest rates: Fed Funds and the ten year Treasury. The Fed Model uses the 10 year, not Fed Funds.
    You stated “The main point is that when interest rates are extremely low, the “Fed model” approach breaks down. No one believes that an interest rate of 1% implies a stock P/E of 100. When rates get too low, it is a sign of danger.”
    But the Fed Model has never been applied to ‘interest rates’ of 1%. In the regressions in your own 2007 posts, 3% (10Yr) is the lower bound.
    So your quote above is moot and unsupported by any data.
    Most important, you said “As interest rates move higher, it is a sign of strength. It will signal P/E multiple expansion.”
    That is clearly false, as shown by your own regressions in the 2007 posts on this blog.
    Do you believe that a discount rate (10yr T, or whatever) is not an appropriate factor in stock valuation?
    There are numerous studies showing that stocks’ duration is greater that the 10yr Treasury.
    Do you now think that your 2007 regressions and these studies all have some fundamental flaw?

  • ron glandt February 11, 2010  

    Aren’t PE ratios already above average? I read recently that the PE ratio of a stock is not an indicator of a stock to rise or fall.??

  • Jeff Miller February 11, 2010  

    Greg — I am delighted that you clicked through to the old article. I spent a lot of time on that one, and I am prepared to defend the conclusions.
    The 100-1 concept was supposed to be illustrative — an extreme example showing that the relationship was not linear. That is clearly the result of my data analysis. The other authors on this topic just “throw out” data that does not fit their method.
    I am comfortable with using the regression results in the article. The point is that investors should not panic when short-term rates start to move higher.
    As to duration — this is an empirical question. Like many such questions with stocks we just do not have enough data to be sure. Meanwhile, the current market valuation is so far off that the point you raise is really quite academic.
    I really appreciate your careful look at this. Feel free to come back or to give me a call to discuss.
    Thanks,
    Jeff

  • Jeff Miller February 11, 2010  

    Ron — PE ratios are above average if you look backward (including a lot of one-time write downs) and also if you ignore interest rates.
    Anyone who does valuation without paying any attention to interest rates is missing a big part of the story, IMHO.
    But you certainly are asking the question on the lips of many.
    Thanks!
    Jeff

  • ron glandt February 11, 2010  

    I believe the Feds want to crank-up some inflation prior to increasing interest rates.
    With real estate, increased interest rates eventually depress prices, depending on the level of inflation, because the higher interest rates add expense. I would expect there is an interest rate level that the result is the same for stocks unless there is also a degree of inflation
    Ron Glandt