When the Fed is pumping liquidity (reducing Fed Funds Rate, instituting Quantitative Easing (QE)), you should follow the market upwards. If the Fed is taking away liquidity (raising Fed Funds Rate, and taking away Quantitative Easing), then be careful in the stock market.
This "Don't Fight the Fed" mantra seems to have worked very well since 2009, as the Fed cuts rates and institutes many Quantitative Easing programs, resulting in the stock market having a very good rally.
If the Fed starts to cut back on Quantitative Easing and raises rates, it is best to be careful in the market.
B. Is "Don't Fight the Fed" still Valid?
Since July 2000 (till July 2014), what is the one year future return of the S&P 500 every time the Fed has raised or cut the Fed Funds rate? Does this validate "Don't Fight the Fed?"
The results are as follows:
1. The S&P 500 return one year after the Fed cuts rates (since July 2000) averages: -14.2%
2. The S&P 500 return one year after the Fed raises rates (since July 2000) averages: 10.1%
Based on the one year forward return after the Federal Reserve cuts or raises rates, the S&P 500 is up when the Fed raises rates, and the S&P 500 is down when the Fed cuts rates.
This is opposite of the mantra: "Don't Fight the Fed!"
C. There is a better correlation using another metric: The actual Fed Funds Rate
Since the "Don't Fight the Fed" doesn't seem to work, is there a better metric to determine whether the one year S&P 500 forward return would be positive or negative?
After researching the data, it isn't whether the Fed is cutting rates or raising rates, but the actual Fed Funds rate plays a big role in the S&P 500 forward return:
The results are as follows:
Since July 2000, the S&P 500 return one year after the Fed changes rates (up or down) or announces a QE program when:
1. Fed Funds Rate is less than or equal to 1%: 13.1%
2. Fed Funds Rate is between 1% and 2% (not including 1%): -1.9%
3. Fed Funds Rate is between 2% and 3% (not including 2%): -8.9%
4. Fed Funds Rate is between 3% and 4% (not including 3%): -7.1%
5. Fed Funds Rate is between 4% and 5% (not including 4%): -6.3%
6. Fed Funds Rate is between 5% and 6% (not including 5%): -2.1%
Based on this, the actual Fed Funds rate seems to have a better correlation with the S&P 500 one year forward return. The best one year S&P 500 forward return is when the Fed Funds Rate is less than 2%. Fed funds rate greater than 2% has a more negative one year forward S&P 500 return.
D. Data Points:
|Date||Fed Funds Start||Fed Funds End||Fed Funds Diff||S&P||S&P Date + 1 year||S&P + 1 year||Return|
|11/25/2008||Start QE1||Start QE1||0||857.39||11/25/2009||1110.63||29.5%|
|3/31/2010||End QE1||End QE1||0||1173.27||3/31/2011||1325.83||13.0%|
|11/3/2010||Start QE2||Start QE2||0||1197.96||11/3/2011||1261.15||5.3%|
|6/30/2011||End QE2||End QE2||0||1320.64||6/29/2012||1362.16||3.1%|
|9/13/2012||Start QE3||Start QE3||0||1687.99||9/13/2013||1687.99||0.0%|