Why Are You Still Watching the Fed?

Following two days of losses instigated by the Cypriot debacle (which is ongoing), the market's focus shifted to the outcome of the Fed's rate-setting meeting today. Stocks rebounded, with the S&P 500 (SNPINDEX: ^GSPC  ) gaining 0.7%, while the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) rose just 0.4%.

Consistent with those gains, option traders pushed the VIX Index (VOLATILITYINDICES: ^VIX  ) , Wall Street's "fear index," down 12% to close at 12.67. (The VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.) As of this afternoon's close, the evidence suggests that U.S. investors have all but forgotten Cyprus and the eurozone's woes and the incident will barely register on the itinerary of this bull market. Mind you, we have yet to establish a new all-time (nominal) high in the S&P 500, so all is not won yet.

Nothing to see here, folks
One can only marvel at the amount of effort that professional investors and analysts expend on tracking, analyzing and forecasting the Fed's behavior, to the point where it has spawned its own industry of Fed watchers. I'm on the fringe of that circus  -- it's an occupational hazard.

I wish I could say this fixation is entirely irrational and unproductive, but that wouldn't be true. After all, in a paper published in Sept. 2011 and revised last June, two staff members of the Federal Reserve Bank of New York found that four-fifths of the U.S. equity premium earned since 1994 was due to abnormal excess returns generated in the 24-hour window prior to Federal Open Market Committee announcements (such as today's.) Four-fifths!

Still, the fact that the bulk of the premium was realized during those periods does not imply that the Fed somehow generated it. Over the long term -- and a 17-year span starts to qualify -- real equity returns are the product of earnings growth, companies' allocation of those earnings and stocks' initial valuation -- and no other factor.

If your time frame is measured in hours, days, or months, following the Fed is a necessity. On the other hand, if it is measured in years -- the equity-appropriate time unit -- you're much better off focusing on the three factors I  identified above. Oh, and if you were wondering, there was zero change to Fed policy today -- the statement was virtually identical to January's.

If you're finally ready to invest based on the three factors I highlighted above, the Motley Fool's chief investment officer has selected his No. 1 stock for this year. Find out which stock it is in the brand-new free report: "The Motley Fool's Top Stock for 2013." Just click here to access the report and find out the name of this under-the-radar company.


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