Reader Gary asks, “What’s your feeling about using the Fed model for market timing?”
It is important to understand how things have worked in the past. When the Fed begins to lower rates, banks, utilities, housing stocks, retailers, tech and auto stocks tend to do well. If rate reductions continue the smokestack stocks will join the party. But once the Fed begins to raise rates again, these things will do poorly; mining stocks, pharmaceuticals, food, beverage, and tobacco stocks will begin to shine. You can sometimes get an early read on what the Fed may up to by watching the behavior of these market sectors relative to each other. For example, you could compare the S&P Discretionary Sector SPDR to the Consumer Staples Sector SPDR. Telecommunications and energy stocks tend to be less affected by Fed actions.
The Efficient Market Theory states that you can not successfully trade on any news event because it is immediately discounted by the market and reflected in the current price. I am not a “true believer” in the Efficient Market Theory. However, it is clear that changes in the mass media have made the market much more efficient than it used to be. For the sake of discussion let us assume that the markets were 50% efficient in the early 20th century when the only source of public information was newspapers and magazines. Then, in the mid-20th century, let us say the markets became 70% efficient when radio and TV enabled more investors to react quickly to news. If that is true, the markets certainly have become at least 90% efficient by now, since the internet allows an ever-increasing number of market participants to react to breaking news and market rumors in real time.
Now if the market is 90% efficient, that means there is a 90% probability that any major development such as a Fed action has been discounted before the announcement and can not be traded on profitably. Many very smart people are watching the Federal Reserve 24/7, ready to move large sums of money with the click of the mouse. More than any other phenomenon, the odds of the Fed changing rates are discounted by the market and reflected in the price of every actively traded security in real time.
Instead of using Fed actions for market timing, I watch investor sentiment as people try to anticipate the Fed’s next move. There will be times when sentiment becomes too one-sided. When every market participant is convinced there is a 100% likelihood of some future event such as an interest rate reduction, it may be worth your while to take the other side of the trade.