History's Guide: Don't Take Your Investing Cues From the Fed

The Federal Reserve might be the most powerful institution in the world. If you're an investor, ignore it. 

The Fed announced yesterday it will continue its $85-billion-per-month bond buying program. Unexpected by nearly everyone, the Dow Jones surged to an all-time high. 

As surprising as the Fed's decision was, the market's reaction was par for the course. According to the Fed's own research, effectively all of the market's gain from 1994 to 2011 came within 24 hours of Fed policy meetings: 

No one can argue the market's long-term gain is due to Fed action alone. Real (inflation-adjusted) earnings nearly tripled from 1994 to 2011, and U.S. economic output per person grew by more than a quarter. 

But short-term traders, who dictate the direction of the market's day-to-day moves, pay more attention to Fed policy than probably any other metric. So the market's long-term gains tend to come in clustered punches around Fed meetings. 

This might seem like a reason investors should pay attention to the Fed's moves, but I think it's the opposite. 

Before the Fed's meeting yesterday, pundits worried about what would happen to stocks when the Fed backed away and the market went back to focusing on nothing but fundamentals. 

But I ask you: When was the last time that world existed? 

The Fed's ability to influence markets began long before the 2008 recession. It's been present for decades. 

The Fed's job is to control inflation and support employment. It has unlimited tools to do this job and extraordinary authority to use them at will. That's been the case since it was created 100 years ago, and it will continue to be the case well into the future. 

Ben Bernanke made it clear yesterday that the Fed will keep its foot on the gas until the economy gets stronger. A stronger economy might be good for stocks -- the last the time the Fed tightened monetary policy, from 2004 to 2006, stocks rose 40%. And if the economy doesn't get stronger, the Fed will keep stimulating ... which might be good for stocks.

This doesn't rule out volatility. Stocks are always volatile. But the idea that the Fed must eventually pull out, throw up its hands, let the economy crash, and walk away for good is not only unlikely, but against its legal mandate. 

Now let's ask a different question: What might happen to markets if the Fed were to stop buying bonds? 

Over the last four years, there have been several instances when the Fed temporarily stopped buying bonds, started anew, stopped again, and so on. Every time the Fed has stopped buying bonds, interest rates fell. And every time it began buying bonds again, interest rates rose.

This is the opposite of what should happen in theory. But it's what actually happened in reality. And reality, as they say, gets the final word. 

Then there's the argument that easy Fed money is propping up stocks. This seems likely -- I'm not arguing against it -- but it's not nearly as clear as some presume.

The S&P 500 (SNPINDEX: ^GSPC  ) is up big since the March 2009 lows, but it hasn't even kept up with inflation since 2007, before the Fed's extraordinary measures began. It seems a stretch to call something that hasn't kept up with inflation a "bubble." And that isn't just a factor of using the previous peak as a starting point. Since 1990, the index has increased an average of 6.6% per year, which is a full percentage point below its long-term trend rate. The cyclically adjusted P/E ratio is now 23 -- high by some measures, but a lower level than has been seen in 62% of months in the last 20 years. 

All I'm advocating is humility. The market is full of analysts and pundits who breathlessly explain what the Fed is going to do next and how the market will react. They are nearly always wrong. Yesterday was a perfect example. 

You do not know when the Fed will cut back. You do not know what will happen when it does. 

Base your investing decisions around your own goals, risk tolerance, and experience. Keep your eye on high-quality businesses, not government policy changes. 

Read/Post Comments (17) | Recommend This Article (55)

Comments from our Foolish Readers

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  • Report this Comment On September 19, 2013, at 6:23 PM, Wills61 wrote:


  • Report this Comment On September 19, 2013, at 6:47 PM, Seanickson wrote:

    I assume maybe youre only talking about postwar data for the price growth data but from 1900 to 2000, the growth rate was about 5.6%, in line with gdp growth. That said the idea of a fed put seems rather silly. Valuations have been a lot higher over the past 20 years and this is primarily because inflation has been so well controlled, i woukdnt expect too much of a shift until this is no longer the case.

  • Report this Comment On September 20, 2013, at 8:29 AM, chris293 wrote:

    The reason P/E's have so high in the last 20 years has been caused by the number of big bubbles that have taken place along with the increase in the money supply. Then we have government spending at local, state, and federal levels unsupported by anything but pipedreams when tax revenues declined with the falling values in housing in 2008. Then as evidences, your Fed research offers a staff report on a puzzle? Get to the point and stop encouraging spending of monies no one pay.

  • Report this Comment On September 20, 2013, at 4:52 PM, jvgfool wrote:

    I look forward to Morgan's articles.

  • Report this Comment On September 20, 2013, at 5:03 PM, brigidl wrote:

    Me too, keep up the good work Morgan

  • Report this Comment On September 20, 2013, at 8:30 PM, tymtested wrote:

    I really enjoy reality proving the pundits wrong. This article provides a wise perspective for volatile market movements.

  • Report this Comment On September 21, 2013, at 12:26 AM, awallejr wrote:

    What amused me is that the traders expected the Fed to announce a taper. They were literally pissed when it didn't happen because they shorted the market and felt betrayed. Tough. Those same traders tried to con the average investor when they tried to poo poo the topic by saying it was ALREADY priced into the market, knowing full well it wasn't.

    I actually am glad the traders got burned mainly because they tried to burn the average joe. Friday was obvious. Triple witching hour, traders wanted revenge. Monday will be an up day.

  • Report this Comment On September 21, 2013, at 3:53 PM, Torree123 wrote:

    Thank you for this extremely relevant and timely article. I have been thinking about how bad it could get if the gov stopped buying bonds (higher interest rates). Now I have information that will allow me to not worry as much. Thanks again.

  • Report this Comment On September 21, 2013, at 4:34 PM, sagitarius84 wrote:

    Hmm, I have always been taught that one should never fight the Fed.

  • Report this Comment On September 21, 2013, at 5:32 PM, mikecart1 wrote:

    I'm excited to see what happens when the taper begins, when unemployment is truly revealed, when the government shutdown affects everyone, when Obamacare backfires, when the debt ceiling is broken, when social security is shown for what it really is....

    Not a pessimist, just an optimist to BUY LOW and SELL HIGH! :)

  • Report this Comment On September 21, 2013, at 5:41 PM, anonymous7171 wrote:

    Morgan always delivers quality articles.

  • Report this Comment On September 21, 2013, at 11:29 PM, SwampBull wrote:

    In the picture of Helicopter Ben shown below the headline, his expression seems to say, "Seriously, Morgan is right. We have no clue what to predict."

    The most difficult part of successful investing is recognizing how much there is that you cannot know. You can make good choices based on the available information, and still be caught blindsided. On the plus side, you can make poor choices and still be rewarded for them in the right environments (QE 3 being one of those 'rising tides floats most ships' situations).

    The difficult question is: if I always agree with Morgan, is that confirmation bias? Since Morgan taught me what confirmation bias is, it must be. Unless it is one of those chicken / egg problems.

  • Report this Comment On September 22, 2013, at 2:58 AM, CraigWPowell wrote:

    With the years I learned to listen to Warren Buffet,

    agree with him that Ben Bernanke did a great job for signaling in 2008 that he’d do whatever was needed to stabilize markets and the next chairman should

    follow his approach to economic stimulus.

    S&P500 2013 chart supports this:

    "S&P500 Forecast Based On Algorithm: Chart Of Last 13 Months Predictions"

    Good Luck!

  • Report this Comment On September 22, 2013, at 7:41 AM, Mathman6577 wrote:

    "Pay no attention to that man (or possibly woman) behind the (Fed) curtain."

  • Report this Comment On September 22, 2013, at 9:21 PM, SkepikI wrote:

    One of your most interesting (to me) articles ever, Morgan. However, I would ask you to do something more in depth (perhaps another article) analysis about the following:

    <Over the last four years, there have been several instances when the Fed temporarily stopped buying bonds, started anew, stopped again, and so on. Every time the Fed has stopped buying bonds, interest rates fell. And every time it began buying bonds again, interest rates rose.>

    I note the key word "temporarily" in the first sentence. This raises alarm bells with me particularly when the world knows its not a permanent change. I would suggest to you this is fodder for some really interesting analysis on your part..... And no I don't have the slightest idea what it portends, but I am very interested. I believe quite firmly that the Feds oppression of bond rates is both noticeable and noticed, and the evidence when the markets bobbled at least twice in the last 6 months pay attention. HOW they pay attention, may be a matter of some debate. What I do know is that (in anticipation of Fed policy change that never comes, the Bond funds and markets have taken a couple of really interesting declines, to the point where the whole income from interest is lost to price declines.

    VERY much intriguing.

  • Report this Comment On September 22, 2013, at 9:25 PM, SkepikI wrote:

    oops, the evidence markets pay attention is when they bobbled at least twice in the last six months... borderline manic ; -)

  • Report this Comment On September 23, 2013, at 8:55 AM, PanchoAlmeja wrote:

    Great article Morgan

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