Updated from Friday, June 13, 2008.
I am a historian by nature, especially when it comes to the U.S. economy and global economics.
I studied the trail of wealth in this country from the robber barons of the nineteenth century, such as J.P. Morgan
and Daniel Drew, to their counterparts in the twenty-first century, the
titans who have made billions over the last several years.
I ate up every bit of information available about the economy from the Crash of 1929 to the boom of the 1990s and everything in between. I devoured every book, article, pamphlet, and cereal box that had anything to do with this subject. For eight years, I tested and tweaked all of my investment theories, using myself as the guinea pig.
As I began my quest to discover how I could build my own personal wealth, I wondered if the wealthy elite I had observed on Wall Street had resources that I could never hope to duplicate. Then, I learned of a group of people from various walks of life who started with modest means but who were able to become multimillionaires with little effort on their part.
These were the "Buffett millionaires," people who made incredible amounts of money by investing in
. The investment made an incredible amount of money for me with surprisingly little effort.
It was as though a light bulb lit up over my head. The answer was to look for opportunities to invest with these Wall Street insiders at attractive prices and then stay on for the ride.
I looked for similar situations to Berkshire and was quite successful. I thought that I had finally discovered the secret to investment success.
Then the technology boom of the late 1990s arrived and the tactic of investing in value stocks stopped working. It was a new world, with rules I did not understand, so I decided to go back to Wall Street to learn more.
I took a position at Sanford C. Bernstein, one of the premier investment research and management firms in New York.
The Incredible Power of the Federal Reserve
During my time at Bernstein, I began to notice the incredible power the United States
had over the availability of money and credit in the financial markets. It seemed as if the then-Fed Chairman Alan Greenspan was in the news almost every day. The Fed seemed to be the 800-pound gorilla, influencing all aspects of the stock market. The importance of corporate performance proved to be minor by comparison. Since my firm focused on individual stocks, my colleagues had little interest in my new research.
I decided to leave and to focus on developing strategies utilizing the powers of the Fed, and testing them with my own money. My own skepticism disappeared as I soon found that the type of stocks favored by Fed policy were in general the true outperformers in my portfolio. Much to my delight, this accomplishment required extremely little trading. Eventually, I discovered that excessive trading activity on my part actually reduced my returns.
The Individual Investor's Edge Over Wall Street Money Managers
Wall Street professionals face intense pressures to concentrate on short-term performance. Advertising, promotions, bonuses and other business metrics reflect this focus. However, if a professional or individual investor can lengthen their timeframe, they can take advantage of opportunities overlooked by Wall Street.
Markets may seem chaotic when you watch them day-by-day, but they tend to be quite logical over extended periods. Plus,
is the most powerful tool for the long term investor. I used these proven concepts as the basis for my investment strategy.
'Follow the Fed'
I wrote the book
about my strategy "Follow the Fed," and to this day, I continue to refinine the formula, adding other criteria and benchmarks to increase this strategy's comparative advantage even more.
The simplest and easiest way to invest in these stocks is through exchange-traded funds (ETFs) that track the
index and the
index, such as the
iShares S&P SmallCap 600 Index Fund
iShares Russell 2000 Index Fund
. The current top two individual stock holdings in the S&P SmallCap 600 ETF are
Cabot Oil & Gas
. The top two stock holdings in the Russell 2000 ETF are
CF Industries Holdings
However, if Fed policy is "tight" (short-term interest rates are greater than or equal to the rate of inflation), then stick with
, represented by ETFs that track the
Dow Jones Industrial Average
, such as the
SPDR Trust, Series 1
Diamonds Trust, Series 1
. The biggest large-cap holding in the SPDR ETF is
, while the Diamonds ETF's largest stake is in
I have back-tested this strategy almost 80 years and it worked over the entire period.
Research has shown that, over time, as much as 90% of mutual funds do not outperform the S&P 500. However, this strategy beats the S&P 500 by almost 3%, exceeding the small-cap outperformance advantage, but with substantially reduced
. (Historically, small-caps have outperformed large-caps by over 2.5%, but with much higher volatility.)
This strategy averages a trade every two to three years and can be implemented using low-cost, broad-based mutual funds, found in almost all 401(k) and retirement plans. However, we tend to focus on index funds and ETFs because of their low costs and expense ratios.
The Fed Today
We have recently entered a negative interest rate environment that favors small-caps, which is likely to continue. Despite the
by Fed Chairman Ben Bernanke, I do not see the Fed raising rates in the near future. There is just too much weighing on the economy in terms of increased unemployment, declining housing prices and higher energy prices.
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Doug Roberts is the Founder and Chief Investment Strategist for ChannelCapitalResearch.com, an independent research firm focusing on investment strategies using the Federal Reserve's impact on the stock prices. He previously held executive positions at Morgan Stanley Group and Sanford C. Bernstein & Co. To learn more about his book, visit www.followthefedthebook.com.