A stock strategy follows Fed rate moves

With two weeks to go before the Federal Reserve’s December 11 Open Market Committee meeting, speculation continues to ramp up about just what the central bank will do next. The futures market seems certain the Fed will lower rates again, as the financial system remains unstable, the economy is slowing and inflation appears under control. But as hedge fund manager Paul Kedrosky notes on his Infectious Greed blog today, someone forgot to tell Philadelphia Fed President Charles Plosser.

Delivering his views on the economy in a speech at the University of Rochester, Plosser largely rejected the idea that the Fed could help ease the subprime crisis with more rate cuts. “Arbitrarily lowering interest rates or providing liquidity to the market does not provide the answers the market seeks,” he said. Furthermore, Plosser expects only a short period of “sluggish growth” before the economy resumes “a sustained expansion” with inflation “above the level I view as consistent with price stability.”

“We will have to remain vigilant on the inflation front and prepared to act as necessary to avoid the risk of undermining public confidence in the central bank’s commitment to price stability,” he concluded. Not a forecast that going to bring additional rate cuts anytime soon.

As investors ponder the Fed’s next move, the CXO Advisory Group’s blog highlighted a timely recent study (PDF file) by three finance professors and a director of the CFA Institute. The four studied how stock market returns varied by sector when the Federal Reserve cut or raised rates between 1973 and 2005. The sectors were the 10 biggies (like tech, financials, industrials etc.) but they divided the group into the six considered subject to the economic cycle and the four considered non-cyclical. Then they tested what would happen if an investor was equally invested in the six cyclical sectors when the Fed was cutting rates and shifted to the four noncyclicals when the Fed was raising rates.

The study uncovered a big pattern, big enough to trade on, according to the researchers. On average, the cyclical portfolio returned 20% a year when the Fed was cutting versus 15% for the noncyclicals. And when the Fed was raising rates, noncyclicals gained 10% while cyclicals gained just 2%. “A simple reallocation tied to changes in monetary policy could have improved investment performance,” the write.

They also looked deeper to make sure the results they were seeing weren’t caused by unrelated market trends. Per year, the sector allocation beats a simple market investment by an average of 3.5% a year

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