One Good Paper: A Stock Market Puzzle

Ben Bernanke speaks during a news conference following a Federal Open Market Committee meeting in Washington, D.C., on Mar. 20, 2013 Photograph by Andrew Harrer/Bloomberg

Each week, Bloomberg Businessweek asks a different economist to recommend one good paper—research, new or old, that should be on our reading list. This week Harald Uhlig, a macroeconomist at the University of Chicago, chose The Pre-FOMC Announcement Drift by David Lucca and Emanuel Moench, both staffers at the Federal Reserve Bank of New York.

The Federal Open Market Committee is as close as America gets to a table of philosopher kings. Eight times a year, the Board of Governors of the Federal Reserve and the five voting chairs of the regional Federal Reserve banks sit in a closed room and make a decision—whether to change monetary policy. Since 1994, the committee has announced its decision at 2:15 on the afternoon of the day it meets. You might expect the FOMC’s announcement to move markets. It does. But since last year, we’ve known that markets move not after the 2:15 p.m. announcement but in the 24 hours before it. Since 1994, the value of the S&P 500 index has increased, on average, 49 basis points the day before the FOMC announcement, an order of magnitude more than on any other day. Again: before. After the announcement, returns average out to zero.

“Sensational,” says Harald Uhlig. It’s not a word that economists normally use. Uhlig, an economist at the University of Chicago, explains that genuinely new observations don’t come along that often. Interesting facts, yes, like a paper he read recently on how Swedish divorce law affects marriage. But “something where you can go into a roomful of people who specialize in this subject, with no inkling that this is coming, and they can’t come up with an explanation,” he says, “that’s really rare.”

The timing of stock gains around the FOMC announcement is such an observation. Uhlig recommends the 2012 Federal Reserve Bank of New York staff report that documents it: The Pre-FOMC Announcement Drift.

The paper’s observation sits atop what is already a long-standing dispute among economists: Why do stocks earn higher returns than bonds? The academics trying to answer that question have at least by now divided themselves into camps. Robert Barro, for example, believes that every couple of decades something disastrous happens to equities, and that this low-probability, high-severity risk underlies all the smaller events that bounce stock prices around and explains why, over time, stocks command a higher return. (Economists call this higher return the “equity premium.”) Now, the New York Fed staff report has determined that what it calls a “staggering 80 percent” of the equity premium since 1994 was earned, yes, in the day before the FOMC announcement. No similar effect was observed for bonds.

Another way to say this: We don’t really have a stock market. We have a pre-FOMC market.

The paper’s authors run through various explanations for their findings, then discard each in turn. “Jump risk,” the possibility that unexpected news may push stocks around, happens after the unexpected news hits the markets. “Investor inattention” is exactly what it sounds like. Investors don’t worry about trades related to Fed policy until shortly before the announcement, when speculations about the FOMC’s decisions start showing up in the news. Even sophisticated investors aren’t perfectly attentive. But the same effect doesn’t show up on the days before other major macroeconomic announcements—jobs figures, say—which should in theory be subject to the same meandering investor attention spans.

“In sum, as of this paper’s writing, the pre-FOMC announcement drift is a puzzle.” Economics papers don’t normally end this way, either. In the year since the paper was released, says Uhlig, no one has come up with a convincing explanation. All he can offer is a warning. “The moment hedge funds see [the paper], there’s such an obvious trading strategy,” he says, “if you write any of this, please attach the caveat that I’m in no position to give investment advice.”

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