Not Such a Simple Equation

In perhaps the most-expected move in the history of the Federal Reserve, the Fed raised the Fed-funds rate a quarter point today, essentially to tell the bond and stock markets that it was aware that inflation is still a possibility, even in the Goldilocks economy. What was less expected, though, was that the Fed also changed its bias away from further tightening. So inflation, Alan Greenspan apparently thinks, is still a very distant possibility.

Stocks (and bonds, interestingly enough) both leaped on the news. If history is any guide, you should take this as an excellent opportunity to sell. As Jeremy Siegel points out in his book Stocks for the Long Run (which is absolutely indispensable, so you should buy it now), “since 1955, the total returns on stocks has been about 7 percent in the 12 months following the 92 increases in the Fed funds rate, while it has been almost 18 percent following the 85 times the Fed funds rate has been reduced.” The average 12-month return since 1955 has been 12 percent.

Now, even 7 percent annually isn’t too shabby, though in these days of outsized stock-market returns it’d probably feel like losing money. But considering that stocks have done only half as well after a Fed-funds hike like the one we saw today, perhaps you should think about, as they say, taking some profits right now.

Actually, you shouldn’t think about that, because in this case history is a rotten guide. The “interest-rate hike = smaller returns” pattern worked great from 1955 through the 1980s, but in this decade it hasn’t worked at all. Stocks have been just as likely to rise in the nine months after a Fed-funds hike as they have been to fall. Today, for instance, if the Fed had gone collectively mad and not raised rates, the sell-off in the stock market would have been massive.

Now, there are obvious times, such as last summer, when cuts in interest rates do seem to send a clear signal that it’s a good time to invest in the stock market. But last summer the Fed cut rates to save the world economy. There are very few times when things are quite that stark.

More to the point, the disappearance of the simple equation between what the Fed does and what the market does speaks to the increased efficiency with which markets now process information of all kinds, as well as to the heightened scrutiny under which the Fed (as well as everyone else) now operates. It’s more and more rare that a Fed move comes completely out of the blue, which means that the Fed’s decisions are more and more likely already to be priced into the market. That doesn’t mean the Fed is less important, because after all what Greenspan is really concerned about is not the stock market but the real economy. But what it does suggest is that it’s harder and harder to make money (or avoid losing money) by following simple rules of thumb. In a market this fast and this big, it’s very hard to be quicker and smarter than everyone else.