Monetary Policy and Stock Market Returns
It came as no surprise when the Federal Reserve announced on Wednesday, December 16, 2015 their decision to increase the federal funds target rate for the first time in nearly a decade. Investors welcomed the news that may have attributed to the 224-point gain on the Dow Jones Industrial Average (DJIA) and the 30-point gain on the S&P 500 Index. Does a 25bp increase in the Fed Funds target rate justify an increase of 1.28-1.47% in stock prices? It does if the consensus of investors believes it. Remember, stock prices at any given moment are a reflection of the aggregate of millions of investors buying and selling decisions. I’ve long held the belief that if a single person expresses the opinion of current stock prices to be either over-valued or under-valued, the opinion stands in contrast with the collective knowledge of all investors who have individually weighed and considered the information at their disposal.
There will be endless debate on how a “tightening” monetary policy may impact stock prices going forward. Capital Markets University (CMU) was created to educate investors, we are not interested in time-wasting activities that offer no beneficial information (like listening to someone tell us what to expect going forward). Instead, we prefer to provide data and research and leave it to our intelligent readers to draw their own conclusions.
The table below illustrates stock market returns1 over the past 30 years along with changes in the effective federal funds rate.
| Years | Change in the effective federal funds rate | Period covered | Stock Market Return (dividends reinvested) |
|---|---|---|---|
| 1985 - 1989 | Increased 1.25% | March 1985 - June 1989 | 18.93% annualized |
| 1989 - 1993 | Decreased 6.74% | June 1989 - December 1993 | 11.86% annualized |
| 1993 - 2000 | Increased 3.53% | December 1993 - September 2000 | 20.79% annualized |
| 2000 - 2004 | Decreased 5.52% | September 2000 - March 2004 | (5.92)% annualized |
| 2004 - 2007 | Increased 4.26% | March 2004 - December 2007 | 9.50% annualized |
| 2007 - 2015 | Decreased 5.15% | December 2007 - March 2015 | 7.09% annualized |
Source: S&P 500 Return Calculator. Federalreserve.gov.
The data provides some very interesting information but is there any discernible information that could be used by an investor? One particular take-away might be that the periods with the largest annualized returns (1985-1989 and 1993-2000) occurred during increases in the effective federal funds rate. While it may be tempting to summarize that stock investors should be optimistic if the effective rate goes higher, I would caution that many (if not most) patterns in the capital markets are not consistent over time and future stock prices will be determined by many factors. The federal funds rate is only a spoke in a very large wheel.
One headline a couple of years ago read, “How the Fed is helping to rig the stock market”. This particular media outlet wasn’t the only one distributing such nonsense. Similar comments were made by many. While there may be some indirect benefit of low interest rates (reduced interest costs could increase disposable income that may increase consumer spending that may increase corporate earnings that may reflect in higher stock prices), it would be quite a stretch (and unsupported by the data I’ve seen) to surmise that a declining effective federal funds rate leads to higher stock market returns. When Fed policy makes it cheaper to borrow money the objective is to stimulate consumer spending. Equating this to the Fed “rigging the stock market” is, in my opinion, media fodder.
The short term price movements of the stock market are unpredictable. There are simply too many variables and too many participants. It’s my belief that a person’s investment experience is enhanced when they have realistic expectations, understand the difference between loss and volatility, practice real (vs. perceived) diversification and stick with a well-designed plan.
- Rick O'Dell
