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Investors Shouldn’t Worry About Predicting the Fed’s Next Move

Most market participants believe the Federal Reserve will shift policy to be more accommodative during 2024. As of April 29, according to federal funds futures pricing, the market anticipates one or two 25 basis point decreases in the fed funds rate between now and the end of 2024. If two changes occur, this would decrease the rate from its current range of 5.25 - 5.50 to a range of 4.75 – 5.00 by year end. The market anticipates the first rate reduction of 2024 will most likely occur in September.   


While many financial pundits are fixated on predicting the details of the Fed’s next move, the EIA team believes that prognosticating about future Fed decisions is of little value. Furthermore, the efforts of market participants in divining Fed actions have been incredibly inaccurate as expectations of Fed rate changes have consistently missed the mark. Finally, even with perfect foresight of the next Fed move, the question remains, how do you exploit the information?


Based on over 30 years of research, the EIA team has concluded that predicting Fed policy decisions is a fool’s errand. The team, however, has concluded that using Fed policy actions to guide portfolio composition has substantial merit. For equity investors, the most important goal should be ensuring that portfolio holdings align with market conditions, that is, their investment strategy should consistently target in-favor stocks. Relying on the founder’s research, the EIA team created the Invest with the Fed (IFED) strategy to enable investors to attain this objective.


The IFED Investment Strategy

The IFED strategy adjusts portfolio holdings to avoid stocks that are out-of-favor. The strategy is an active, rules-based investment approach that captures the best features of both active and passive investing.


Like a passive approach, the IFED strategy is rules-based to limit portfolio turnover and avoid trading on emotional considerations. However, the strategy includes an active feature that adjusts portfolio composition to avoid applying an out-of-favor investment style when market conditions change. The strategy’s effectiveness in differentiating stocks that are well-positioned for the prevailing market environment from those that are poorly suited for the environment is illustrated in Exhibit 1.


Exhibit 1. Stock Performance for Portfolios Ranked by IFED Score 

Exhibit 1 shows performance for the five quintiles formed using the IFED methodology over the 25-year period from 1999 through 2023. The first quintile contains stocks with the highest IFED Scores, that is, stocks best positioned for the prevailing environment. In contrast, the stocks in the fifth quintile have the lowest IFED Scores i.e., stocks most poorly positioned for the environment.


The IFED methodology incorporates two features that enhance portfolio performance. First, the strategy selects stocks with the highest IFED Scores. Second, rather than value weighting the constituents, the methodology weights the constituents by IFED Score. This explains the observation that even the 4th quintile beats the S&P 1500. Note that by reverse weighting the lowest quintile, the portfolio return drops from 5.70% to 3.90%, which highlights the effectiveness of the unique weighting feature. This observation may be of particular interest to investors interested in implementing strategies involving combinations of long and short positions such as a 130/30 approach.


The effectiveness of the IFED strategy is readily apparent from the consistent progression of returns across the five quintiles. The methodical return progression confirms that the strategy’s superior returns are systematic and not driven by a limited sample of extreme returns.


IFED Non-Customized Style Portfolios

EIA’s five non-customized style portfolios are formed by ranking stocks in their respective investment universe by IFED Score and selecting the top 75 stocks. The 75 stocks are then weighted by IFED Score, rather than market cap, when forming portfolios. For example, IFED-A starts with the largest 1,500 U.S. stocks and selects the 75 with the highest IFED Scores, i.e., top 75 stocks from quintile 1. These 75 stocks are then weighted by their IFED Scores, so that those that are best aligned with market conditions play a more prominent role in portfolio performance.


The performance of EIA’s five non-customized IFED portfolios over various periods is reported in Exhibit 2.


Exhibit 2: IFED Portfolio Performance over Various Periods (through March 2024)

The effectiveness of the IFED strategy is established based on the superior performance of the five IFED portfolios over time. Out of the 30 cases, 29 of the alphas are positive. Furthermore, in most cases the alphas are noteworthy. The consistency of outperformance across both time and portfolio type confirms the robustness of the IFED methodology.


Economic Foundation of the IFED Strategy

The IFED strategy is comprised of two distinct components. The first component gauges Federal Reserve actions to classify the market environment into one of three categories, expansive, restrictive, or indeterminate. The second component builds on the first and uses twelve firm-specific metrics to select stocks that have features best aligned with the identified market environment. When a shift in the market environment is identified, the portfolio is reconstituted and rebalanced to favor stocks with features that match the new environment.


In addition to its role as lender of last resort, the Federal Reserve has a dual economic mandate, which is to maintain price stability and promote full employment. To manage such lofty objectives, the Fed has been granted tremendous powers over the economy and financial markets. Specifically, the Fed has been bestowed control over the nation’s money supply i.e., aggregate fund availability.[1]


The Fed faces considerable challenges in implementing monetary policy for several fundamental reasons. First, the Fed’s two objectives are promoted by what are often contradictory economic conditions. Price stability generally aligns with weak economic growth, whereas full employment aligns with strong economic growth. Second, Fed policy actions may take several months to work through the financial markets and have a measurable impact on economic conditions. Third, the impact of Fed policy actions depends on how market participants react to the execution of Fed policy actions and the consequences of the Fed actions. Furthermore, the reactions of market participants depend on their expectations, economic situation, and emotional state. Fourth, Fed policy actions are interjected into a global economy that is constantly bombarded by global economic shocks. Given the complications involved, the Fed indeed has a difficult job.


Since money represents the life blood of an economy, Fed policy decisions play a crucial role in the economy’s health and the actions of market participants. A policy action may require several months to impact economic conditions; thus, Fed actions must anticipate future economic developments, particularly regarding inflation and economic activity. Fed actions must be implemented at the first signs of economic deviations; however, acting fast is a recipe for disaster if the Fed has not accurately interpreted its models and the economic data. Furthermore, the Fed must be prepared to follow up its actions if the initial impact is inadequate.


Given the Fed’s economic influence and its mandate, we believe that by relying on Fed policy actions, the IFED strategy integrates a forward-looking feature, and has an underlying economic justification. Fed policy actions reveal insight regarding future fund availability and the Fed’s validated forecast of future economic conditions. Obviously, the Fed is never going to execute policy perfectly; however, even when the Fed misses the mark, its policy actions have economic consequences that impact security returns. EIA’s founders spent over 30 years studying these return patterns and designing the optimal strategy to capture them.


The Current Situation

In the current situation, May 2024, the Fed is expected to move toward a more accommodative policy sometime later this year. The quandary for the Fed is that such stimulus if applied too early or with too much vigor could promote a return to heightened inflationary pressures. The Fed’s policy actions when they occur will signal the Fed’s plan of attack and its prediction regarding future economic conditions. As shown in Exhibit 3, a shift from its current “restrictive” position to an “expansive” environment signals that price stability is no longer the Fed’s top priority and instead full employment is assigned top billing. Alternatively, the Fed may shift to an “indeterminate” state signaling that it will maintain a balanced attitude toward its two objectives. Either decision represents a dramatic shift in policy objectives, which the EIA team believes justifies a corresponding reallocation of portfolio assets.


Based on its models and global economic data, however, a third option is possible in that the Fed may decide to delay the first rate decrease until 2025. With such a decision, the IFED strategy would reconstitute and rebalance the IFED portfolios to incorporate updated firm financial metrics but would continue to favor the same features when selecting securities.


Exhibit 3. Selected Data by Market Environment, January 1999 – March 2024


How the IFED Strategy Captures Alpha while Avoiding Downside Risk

As a rules-based strategy that relies on fundamental shifts in Fed policy, IFED portfolios have historically been reconstituted and rebalanced approximately 1.8 times per year. Thus, the strategy avoids the harmful effects of excessive trading and knee-jerk reactions that tend to afflict active discretionary strategies.


The IFED strategy is always full invested and relies on twelve diverse firm financial metrics to select stocks. Several of the metrics favor firms with quality features, e.g., high profitability and balance sheet strength, thus, the holdings are distributed over a broad cross-section of quality stocks. This prevents the strategy from materially underperforming when unusual forces, such as a pandemic or banking crisis, drive returns. The strategy selects quality stocks that are optimally aligned with market conditions, which allows the strategy to prosper when normal return patterns prevail.


Exhibit 4 presents risk statistics for each of the five IFED style portfolios. The data is reported for the full period and since they were first produced in January 2020. Note, all IFED indexes apply the same IFED methodology but are distinguished based on the starting universe of stocks. For each portfolio, the alpha, tracking error, and capture ratios are calculated relative to the portfolio’s benchmark. For example, the capture ratios for IFED-LV are derived relative to the S&P 500 Low Volatility Index.


Exhibit 4. Performance Measures for IFED Portfolios (through March 2024)

The risk statistics align with the IFED strategy’s intention, which is to prosper when normal market conditions prevail, while limiting underperformance when unusual events drive returns. The superior alphas clearly result from a combination of outperformance during both up and down markets. The upside/downside statistics, particularly the upside capture, indicate that much of the tracking error results from overly strong upside return movements, which of course, are embraced by investors.


The similarity in performance between the full period and the live period since January 2020 provides further support for the strategy’s efficacy. Three of the indexes reported superior performance for the full period, whereas two outperformed during the recent period. The upside/downside measures follow the same pattern.


EIA’s Customized, Live Portfolios

EIA has launched two customized IFED indexes in the past four years. Its initial customized index, Nasdaq IFED-L, is a U.S. large-cap index and was launched in June 2020. Nasdaq IFED-LV is a U.S. low volatility index and was launched in July 2022. Each index applies the IFED methodology to a unique universe of U.S. stocks and incorporates various constraints on the stock holdings. The live performance of each index is presented in Exhibit 5.


Exhibit 5. Nasdaq IFED-L and Nasdaq IFED-LV Annual Returns Since Launch

The live performance of EIA’s two customized indexes aligns nicely with the long-term performance of the five style portfolios discussed previously. Each index has performed well despite the uncertainty created by rising interest rates, inflation concerns, and worries about fiscal and monetary actions.


Wrap Up

The experts frequently get it wrong when it comes to predicting Federal Reserve actions. There are too many unforeseen factors that can lead to embarrassment for even the most gifted forecaster. Fortunately for investors, the EIA team has created the IFED strategy, which relies on observed Fed actions, rather than perfect foresight.


Why should you trust that the IFED strategy will work? There are three fundamental factors supporting the robustness of the strategy. First, the strategy was created based on over 30 years of academic research and relies on the basic principle that Fed monetary policy matters to the markets. Second, backtested performance confirms that the strategy has produced superior long-term performance. Third, the strategy’s live performance since index launch handily beats its benchmarks and is consistent with the long-term backtested results.


 

[1]For investors targeting cryptocurrencies, something to think about is whether the power to control the nation’s money supply should, or would, ever be allowed to slip away from the central bank.

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