Five Reasons Not to Fight the Fed

Many investors know the adage, “Don’t fight the Fed,” which essentially states you should go long on the market when the U.S. Federal Reserve is in an accommodative, easing policy framework, and use caution on equities when the central banker starts to tighten.

That strategy is why there is all this recent chatter about tapering. If the Fed begins to tighten (by withdrawing stimulus), common investment wisdom suggests being cautious with your investments is the best course to follow.

But why should you follow the Fed, and not bet against it? Let’s consider five reasons, and perhaps you’ll get a better sense of whom you are up against as an investor.

• History

Like most rules of thumb, don’t fight the Fed has some basis in fact. Historically, stocks have performed well in times of Fed easing and less well when the Fed tightens.

Of note, many investors follow the "three strikes and you’re out" rule, which says sell on the third interest rate hike, not the first.

The thesis here: The Fed tightens to slow down the economy, but it takes a while to actually make an impact because of the lagging impact of higher interest rates.

The economy — and stocks — can do very well for the first couple of rate hikes. But by the time the third interest rate hike occurs, the impact of the others starts being felt in the economy, and things slow down.

• Surprises

One of the Fed’s most powerful tools is surprise. It can, and has, done many things that investors did not expect (both good and bad). For example, on Jan. 3, 2001 the Fed in between meetings surprisingly cut the funds rate to 6% from 6.5%. The result of this move: The Nasdaq rose 14.2% in one day.

• Timing

The Fed has an infinite time frame and, as a governing body, it cares more about the long term than the short term. It doesn’t care if you go broke fighting it. It never dies. It is like a robot, and will keep doing what it thinks it needs to do, until its plan works or it decides to do something else.

Right now, for example, many market pundits expect the Fed’s quantitative-easing program to continue forever.

• Money

The Fed has an unlimited amount of money and it can print money for whatever purpose it chooses.

It is currently buying US$86-billion in bonds each month to prime the economy with excess liquidity in an effort to boost employment and inflation. Since the money is simply created out of thin air and not backed by anything, the Fed can print billions, even trillions.

One day, this is going to cause problems. But until then, the Fed will simply do whatever it wants to.

• Rule changes

The Fed can change its own rules at any time to its advantage.

In the financial crisis, the Fed implemented many new programs to reduce stress on the banks. The Troubled Asset Relief Program (TARP) was set up to buy all sorts of garbage assets from the banks. There were rules prohibiting short selling. There were changes to regulations. Basically, anything that could help out was allowed.

Some investors lost a lot of money because of these sudden, random rule changes. But the Fed doesn’t care — it had the bigger picture in mind. 

Consider this the next time you are thinking about fighting the Fed with your investments: Pretend you are sitting down at a poker table. One of the players (the Fed) has an unlimited amount of money, will never leave the table, and can randomly change the rules while you are playing. In addition, your opponent has proven in the past to be formidable, cannot be read and often surprises players with its moves.

After all those considerations, you then need to ask yourself: Why am I sitting at this table?

Peter Hodson, CFA, is CEO of 5i Research Inc., an independent research network providing conflict-free advice to individual investors (www.5iresearch.ca).