Forget 'sell in May,' just buy on FOMC days: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

(Reuters) - For the past 30 years job one for investors has been to get the Federal Reserve right.

And getting the Fed right seems to have been a one-step process: buy on Federal Open Market Committee decision days.

Don’t worry about what they are going to do: just buy. Don’t think about valuation: just buy on FOMC days.

Some figuring from James Montier and Philip Pilkington at fund managers GMO has shown that FOMC days account for 25 percent of the real returns on the S&P 500 since 1984.

Remember, there are eight FOMC days a year, out of 252 days markets are typically open.

“One of our bright young colleagues, who is considerably more statistically sophisticated than we, calculated that the chance of this occurring randomly was only 0.0086 percent (that is, 86 out of 1 million). As he put it, 'The odds are astoundingly low!',” Montier and Pilkington write. (https://www.gmo.com/docs/default-source/research-and-commentary/strategies/asset-allocation/the-stock-market-as-monetary-policy-junkie-quantifying-the-fed's-impact-on-the-s-p-500.pdf?sfvrsn=3)

What’s more, if you remove particularly strong upwards moves on two easing days in 2008 there was little or no statistical significance to the difference between how the market did on up, down or hold FOMC days.

“In essence it appears that the stock market reaction wasn’t driven by easing so much as it was by the fact that the FOMC was meeting at all!"

In this context doing your homework was probably a big mistake for most investors, because most people, having looked at the relationship between stock prices and company earnings would have, very often during the past few decades, expected mean reversion.

And indeed, GMO as an experiment replaced FOMC day returns with a typical S&P day and then worked out what they call a Monetary Policy-Adjusted Cyclically Adjusted Price-Equity Ratio. No surprise, the market gravitated more towards its historic valuations if FOMC days were excluded.

GMO’s work builds on an earlier study by Federal Reserve researchers David Lucca and Emanuel Moench, who documented the so-called pre-FOMC drift of stocks moving higher into, on and just after Fed monetary policy decisions. (https://www.newyorkfed.org/research/staff_reports/sr512.html)

GMO showed that the market didn’t really care about the direction, per se, of interest rate moves. Instead stock buyers seem motivated by the tender loving care of the Fed, which seems to stoke animal spirits among investors who know a good thing when it comes their way.

DO ALL GOOD THINGS PASS?

Knowing that the thing to do over the last 30 years is to buy on Fed days is fine, but an entirely different thing from knowing what to do now.

Looking at how the Fed is now running monetary policy in relation to the data inputs is perhaps not a great guide for whether supporting market valuations will continue to be both one of their goals and in their gift.

“If the Fed was using an average of Volcker and Greenspan’s response to data as implied by standard Taylor rules, Fed funds would be close to three percent today,” hedge fund manager Stanley Druckenmiller of Duquesne Capital said last week.

“In other words, and quite ironically, this is the least 'data-dependent' Fed we have had in history. Simply put, this is the biggest and longest dovish deviation from historical norms I have seen in my career.”

Stephen Jen of SLJ Macro Partners, a hedge fund firm, is similarly puzzled by the relationship between the data as it comes in and the Fed’s stance towards monetary policy, saying it gives some credence to the idea that a dovish deal was struck months ago among global central bankers.

"The behavior of the Fed since (the G20 meeting) is totally consistent with this hypothesis because the Fed seems less U.S. data dependent and more market dependent and China dependent," Jen wrote in a note to clients.

The real issue boils down to two questions:

1 - Will the Fed continue to want to support the market?

2 - Will the market play along?

It would be foolish at this point to start betting that the Fed will suddenly make better allocation of capital a goal of more importance than market support. If they’ve been doing something since 1985 it is hard to see how or why they stop now.

More likely to upset matters is not a Fed without regard for market valuations but a Fed the market no longer believes powerful.

Given the negative reaction in Japan and Europe to negative interest rates the bigger risk might not be the Fed hiking later this year, but what happens if they are forced to cut back towards zero.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at [email protected] and find more columns at http://blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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