Making Sense of the Fed

By Matt Richey (TMF Verve)

ALEXANDRIA, VA (June 28, 1999) -- The market cuts left... then right... whoa! now it's up... ooh, now it's down. Like Barry Sanders darting around defensive backs, you never know where stocks will go next these days. If you've been following the headlines, you probably know that the market has caught a case of the interest rate blues. From a long-term perspective, this is pretty much a non-event, but it looms large in the here and now, so let's talk about it. But first, I have a little story to share.

Back when I was in high school, I had an introductory economics class in which I had to write a weekly summary about a newspaper or magazine article related to current economic news. At the time, I didn't know anything about the stock market, except that it seemed fascinating, so I regularly reported on a stock market recap that showed up each Sunday on page two of the business section in our local paper, The Tennessean.

Although I didn't realize it at the time, these articles gave only the vaguest of explanations as to why the major market indices advanced or declined during the week. Nevertheless, after doing this assignment for a few months, I began to notice a pattern: optimism or worry about interest rates controlled the market. As rates ticked up a few hundredths of a percent, everybody got scared. As rates came back down, the market rallied in celebration. Almost every week, the tide would turn from dreadful fear to joyful exuberance. In my naivete, I thought, "What a joke! These wise guys can't make up their mind!" I remember telling my dad, "This stock market game is a cinch. Just buy when Wall Street is scared and sell when they're happy."

I may have been naive and I certainly came to the wrong conclusion about trading being a good idea, but I was definitely onto something. Without the slightest clue about the economics of interest rates or the impact of actions by the Federal Reserve, I came to understand an important lesson about the stock market: Over the short-term, the direction of stocks is controlled by the emotions of fear and greed. And oftentimes, these emotions are driven by concern over interest rates and speculation over the Fed's next move.

That's exactly what we're seeing right now. Ever since May 18, when the Fed announced its change in bias to an interest rate increase, the market has been on pins and needles. The reason for this worry is because historically stocks have closely tracked the Fed funds rate with an inverse relationship. That is, as the Fed funds rate moves up, stocks go down; and as the Fed funds rate gets notched down, stocks go up. According to Jeremy Siegel's Stocks for the Long Run, since 1955, stocks have averaged only a 7% return in the 12 months following the 92 increases in the Fed funds rate, versus an 18% return following the 85 decreases in the rate. Let me repeat that: 7% when rates go up; 18% when rates go down.

See why the market is panicking? With this historical trend firmly in place, stocks are struggling in the face of a likely 25 basis point (or 0.25%) increase when the Federal Open Market Committee, or FOMC, meets tomorrow. Plus, there are worries that the Fed may be on its way to additional rate increases in the months ahead.

The 7% vs. 18% evidence is exactly why the Wise say, "Don't fight the Fed," meaning that if the Fed is ratcheting up rates, steer clear of stocks. In addition, the Wise are quick to remind that rising interest rates were a direct cause of the flat market of 1994 and the infamous October correction of 1987. The verdict of history and the scary stories of the Wise are all saying, "Get out of stocks!"

In part, the warnings of the Wise are correct. Interest rates are indeed the most important influence on stock prices in the short and intermediate run. Since stocks and bonds compete directly for investors' money, higher interest rates cause bonds to become increasingly attractive, and thereby suck money from the stock market. In addition, higher rates create higher borrowing costs for debt-bearing corporations, which in turn reduces their earnings. Finally, higher interest rates cause stock investors to discount future earnings at a higher rate, which reduces the present value of those earnings. For those three reasons, investors react negatively to the threat of higher rates.

But -- and this is what really counts -- for the long-term investor, these interest rate worries are irrelevant. Since 1802, despite all the economic ups and downs and the major structural changes, U.S. stocks have returned approximately 7% after inflation. Even with all of the inflation and deflation, booms and busts, and war and peace of the last nearly 200 years, stock investors have doubled their real purchasing power every 10 years.

If that's not enough to convince you, also consider that the historical trend in stock returns following Fed action breaks down in the 1990s. Since 1990, stocks have performed better in the 12 months following a rate increase, than a rate decrease. Following the 7 rate increases, stocks have increased an average of 16.2%, versus only 12.7% following the 11 rate decreases. Most likely, this reversal in the historical trend is due to better Fed policy.

As Alan Greenspan reiterated in his most recent testimony, the Fed's goal is to maximize sustainable economic growth. The implication of such a policy is that whether the Fed is increasing or decreasing rates, as long as they're doing the right thing, the economy will be improved, and by consequence, economic growth and corporate prosperity will continue. And as long as the economy prospers, so do stocks.

Over the long haul, interest rates will continue to rise and fall, but through appropriate policy decisions, the economy will do better more often than not, and long-term investors in stocks will reap the benefits.

If you have any questions about interest rates and such, drop by the Rule Maker Beginners board (linked below). Beginning tomorrow and for the rest of the week, we'll be sharing some personal stories about when your Rule Maker managers were more foolish than Foolish. Have a good night.

06/28/99 Close

Stock Change    Bid
AXP   +2 13/16  125.25
CHV   -  5/8     89.50
CSCO  +  5/8     61.94
EK    +  15/16   70.44
GM    -  1/16    63.44
GPS   +1 3/16    46.88
INTC  +1 11/16   57.00
KO    -  3/4     61.13
MSFT  +1 13/16   86.75
PFE   -  7/16   101.00
SGP   -  1/8     48.69
TROW  +  9/16    36.38
XON   -1         75.19
YHOO  +9 5/8    156.50

                  Day     Month  Year    History
        R-MAKER  +1.51%   3.42%   8.28%  37.01%
        S&P:     +1.22%   2.27%   8.89%  34.70%
        NASDAQ:  +1.95%   5.34%  18.69%  57.45%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     86.75   121.67%
   6/23/98   68 Cisco Syst    29.21     61.94   112.08%
    5/1/98 82.5 Gap Inc.      22.91     46.88   104.58%
   2/13/98   44 Intel         42.34     57.00    34.63%
   2/17/99   16 Yahoo Inc.   126.31    156.50    23.90%
    2/3/98   22 Pfizer        82.30    101.00    22.72%
   5/26/98   18 AmExpress    104.07    125.25    20.36%
    2/6/98   56 T. Rowe Pr    33.67     36.38     8.02%
   8/21/98   44 Schering-P    47.99     48.69     1.45%
   2/27/98   27 Coca-Cola     69.11     61.13   -11.55%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     75.19    16.87%
   3/12/98   20 Eastman Ko    63.15     70.44    11.54%
   3/12/98   15 Chevron       83.34     89.50     7.39%
   3/12/98   17 General Mo    72.41     63.44   -12.39%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   48 Microsoft   1878.45   4164.00  $2285.55
   6/23/98   68 Cisco Syst  1985.95   4211.75  $2225.80
    5/1/98 82.5 Gap Inc.    1890.33   3867.19  $1976.86
   2/13/98   44 Intel       1862.83   2508.00   $645.17
   2/17/99   16 Yahoo Inc.  2020.95   2504.00   $483.05
    2/3/98   22 Pfizer      1810.58   2222.00   $411.42
   5/26/98   18 AmExpress   1873.20   2254.50   $381.30
    2/6/98   56 T. Rowe Pr  1885.70   2037.00   $151.30
   8/21/98   44 Schering-P   2111.7   2142.25    $30.55
   2/27/98   27 Coca-Cola   1865.89   1650.38  -$215.52

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon       1286.70   1503.75   $217.05
   3/12/98   20 Eastman Ko  1262.95   1408.75   $145.80
   3/12/98   15 Chevron     1250.14   1342.50    $92.36
   3/12/98   17 General Mo  1230.89   1078.44  -$152.45

                              CASH     $70.09
                             TOTAL  $32964.59

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.

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