Following the Fed

Ever since Fed Chairman Alan Greenspan hinted that the board would be at least changing its bias in a speech earlier this month, there has been a lot of analysis as to whether the Fed will ease and about what impact a change in its stance could have on financial markets.

There are two ways to analyze the Fed . Many commentators and investors focus on what they think the Fed should do, often based on their investment holdings. I believe this approach often leads to errors. I know too many people who were long tech stocks this summer, and were hopeful that the Fed would bail them out after those stocks faltered, only to see further declines.

I've always believed that it's much more profitable to try to figure out what the Fed will do, whether or not you personally agree with it. This used to be difficult because the Fed didn't openly reveal what it was going to do. But since the Fed started becoming more open nearly seven years ago, the task has become much easier.

Knowing whether the Federal Open Market Committee is taking an easier or tighter stance allows you to objectively figure out whether to be more aggressive or conservative with your investments. Just by following the rise this year of oil and the consumer price index , and the Fed's comments about them, it should have been clear that a less aggressive investment stance was called for. You might not have agreed with the Fed's conclusions, but the important thing (at least when it comes to investing) is to make money. I wasn't writing for RealMoney.com at the time, but James Cramer made two incredible calls this year, telling people to take something off the table in March and again in August.

Now it looks like the Fed is about to embark on an easier policy, if not on Tuesday, then early next year. With oil coming off its highs, inflationary risks have decreased while weakness is now hitting the auto companies and their vast number of employees, suppliers and dealers.

There has been a lot of commentary on RealMoney.com suggesting that you have to buy stocks when the Fed starts easing. Now there is evidence as to just how strong the impact of the Fed can be. The Association for Investment Management and Research, which grants the CFA charter to qualified investment professionals, has just released a study by Gerald R. Jensen, Robert R. Johnson, and Jeffrey M. Mercer.

The study, called The Role of Monetary Policy in Investment Management, looks at several decades of market behavior, examining how returns for markets and sectors differ in times of expansive and restrictive monetary policy.

They define expansive periods as the time between an initial discount rate cut and the time it is moved in the opposite direction. A restrictive period runs from the first discount rate hike until it is next lowered. Every month is considered to be either expansive or restrictive, except for the initial month of a period, which isn't counted. They chose to look at the discount rate rather than the federal funds rate because it provides the clearest signal of the intent of monetary policy. They did note, though, that their results would have been very similar had they used the fed funds rate to classify time periods.

They present their findings in terms of mean monthly returns, and the results are striking. For the period from 1960 to 1998, the major asset classes performed very differently depending on the monetary environment.

Time to Go Long? Stocks and bonds do better when the Fed is easing

Source: Association for Investment Management and Research

Short-term instruments, like Treasury bills, perform better when the Fed is tightening, while bonds and stocks do better when the Fed is easing. This is pretty intuitive, but it is the magnitude of the change in stocks (which the authors define as the value-weighted New York Stock Exchange, American Stock Exchange and Nasdaq index) that really struck me. If I had had the benefit of this study earlier this year, I would have had fewer longs and more shorts than I did this summer. Now that it looks like the Fed will be more relaxed in 2001, I'm planning to trade more heavily from the long side.

Another thing that jumps out at me is the issue of timing. While it's nice to be long the exact moment the Fed eases, it's not necessary to catch the absolute bottom. There are plenty of good returns to be had once the Fed is on your side.

The authors also looked at the performance of individual equity sectors from 1962 to 1998. While all sectors had positive mean monthly returns, there are very different patterns depending on whether the Fed is easing or tightening. I've arranged them from the groups with the biggest performance differential between tight and expansive periods to those with the least change.

What to Do? While all Sectors had positive returns, there are different patterns depending on whether the Fed is easing or tightening

Source: The Association for Investment Management and Research

It's important to remember that these are mean returns, and that nothing goes straight up or down. But with this study in hand, I've got a better idea of where to focus my research efforts as we begin the new year. While financial stocks like Fannie Mae (FNM Quote - Cramer on FNM - Stock Picks) and Freddie Mac (FRE Quote - Cramer on FRE - Stock Picks) are often the first to react to an easier Fed, there may be even more attractive opportunities down the road.

If you would like to buy a copy of the study, you can contact AIMR by writing P.O. Box 3668, 560 Ray C. Hunt Dr., Charlottesville, Va., 22903-0668, or by calling 1-800-247-8132 or 1-804-951-5499. The e-mail address is [e-mail] .