Watch What the Fed Does, Not What It Says
Economic Index Associates (EIA) created the IFED methodology, which is a patent pending approach that classifies monetary conditions into one of three environments: restrictive, indeterminate or expansive. Our 30+ years of research confirms that this classification system is very effective at identifying shifts in Fed policy – even when those shifts are subtle and not fully recognized by most investors. More importantly, the IFED methodology has been proficient in forming portfolios positioned to prosper during prevailing market conditions.
Most investors would probably not be surprised to learn that recent Fed actions signal a shift in monetary policy. They would probably be extremely surprised, however, to learn that the shift is to an expansive or easy money policy. For all the talk about the Fed moving to a restrictive or tighter monetary policy position, the IFED model indicates that in December Fed policy actually moved from its late summer posture of indeterminate to an expansive posture.
The federal funds rate, which plays a key role in the IFED model, had marched gradually up from its Spring 2021 level of 0.05% to 0.10% in mid-Summer 2021. This increase signaled that Fed actions in the short-term market were resulting in a reduced supply of funds (i.e., tighter conditions). This trend, however, reversed itself in the last few months as the rate has declined back to 0.08% for November 2021. We believe this respite in Fed tightening is only temporary and the Fed will get more serious about battling inflation in earnest in 2022. In the meantime, the IFED model suggests the shift offers an opportunity for investors to reposition their portfolio weights appropriately to correspond with this more accommodative Fed posture.
The IFED model adjusts portfolio composition to take maximum advantage of a newly established monetary environment. The model relies on a monetary indicator to identify a shift in current, as well as future, market conditions. Thus, the IFED model is a dynamic, proactive strategy, which contrasts with many strategies that are backward looking.
The following section provides information regarding the composition and characteristics of the IFED Large-Cap US Equity Index (IFED-L) and presents justification for its holdings. In addition to SMAs that track the IFED-L, the index is tracked by two ETNs that are sponsored by UBS, IFEDL and FEDL. IFEDL tracks the index directly, whereas FEDL is a leveraged version, which applies a two-times multiplier to IFED-L.
What is the new composition of IFED-L? Why is it optimal?
The tables below identify IFED-L’s largest holdings, its sector composition, and several value-based metrics before and after the index rebalance on December 9, 2021.
The proprietary IFED model relies on twelve extensively researched and widely used firm-specific metrics to select stocks that are likely to outperform in a newly identified monetary environment. The model is a stock selection strategy and does not target specific sectors. Our research shows that the characteristics of firms that outperform in expansive environments differ fundamentally from those that outperform in indeterminate or restrictive environments. Since the IFED model identified a shift from indeterminate to expansive, the portfolio composition shifted accordingly. The portfolio composition shifted to firms with higher price multiples and lower dividend yields (i.e., greater growth prospects). These metrics align with the increased allocation to information technology firms and slightly smaller sized firms.
Overall Market Commentary
The IFED-L portfolio composition shifted substantially on December 9th. After the rebalance, the portfolio is comprised of 70 stocks. The largest holdings prior to the rebalance were General Motors, Ford and Berkshire Hathaway, whereas, post-rebalance, the largest positions are in Wells Fargo, ConocoPhillips and Palo Alto Networks. Additionally, there is only one financial firm in the top twelve holdings in the new portfolio, whereas five of the top twelve holdings in the old portfolio were financial firms.
With the rebalance, we believe the portfolio is positioned to capitalize on the expansive policy posture of the Fed and an expected turn-of-the-year effect. We expect firms with greater growth prospects to be better positioned to capitalize on the expansive policy and the inflows of capital that tend to accompany the ushering in of a new year. The characteristics of the new portfolio align with this definition as the portfolio has witnessed a marked increase in its price multiples and its level of systematic risk. Finally, the new portfolio is composed, on average, of smaller firms, reflecting the fact that smaller firms have historically outperformed larger firms in expansive monetary policy periods.
The proprietary IFED model applies a unique combination of top down and bottom-up analysis, as monetary policy determines the investment environment and stocks are selected with characteristics that best align with that environment. While sectors are not targeted in the model, stocks in certain sectors have common financial characteristics that are conducive to outperformance in each environment. With Fed policy shifting to more accommodative, the December rebalance produced a larger allocation to information technology and energy, whereas smaller weights are now allocated to financials and industrials.
In summary, IFED-L has a large active share (the percentage of stock holdings that differ from the S&P 500) because it selects and weights component stocks by their IFED score. As the rolling alpha and cumulative returns of IFED-L (shown in the charts below) attest, this bodes well for long-term investors seeking to compound their returns over many years. The most popular (glamour) stocks (e.g., FAANGM) are often omitted from IFED-L because the IFED approach targets companies that are attractively valued for prevailing market conditions. Glamour stocks are typically priced for perfection without regard to the current environment. In general, the IFED strategy is designed to outperform over long periods of time based on capturing underlying market patterns that our research confirms are systematically integrated into long-term security returns.
In summary, with respect to Federal Reserve monetary policy, we believe investors should heed the words of Winston Churchill who said “I no longer listen to what people say. I just watch what they do. Behavior never lies.”