Just a Matter of Time

In his early years as the publisher of a highly rated newsletter, Martin Zweig popularized two market rules. The title of the first one, “Do Not Fight the Tape” comes from the days when day traders watched the ticker tape and not the click by click updates of computer charts. Another popular moniker for the same rule is “The Trend is Your Friend.” For momentum traders, this is the basic rule to live and die by.

The second rule, “Do Not Fight the Fed” summarizes two monetary rules credited to the legendary Edson Gould, namely “Three Steps and Stumble” and “Two Tumbles and Jump.” The steps and tumbles refer to the changes in monetary policy made by the Fed. These rules originally covered any changes the Fed could make to margin requirements, reserve requirements for member banks, or federal fund rates.

Over the last 25 years, the Fed has only used the interest rate changes to signal shifts in monetary policy. Monetary variables, be they simple changes in federal fund rate or in complex models based on interest rates are of little use to trigger-happy traders. They are instead effective in providing long-term signals for major reversals in equity and interest bearing securities. The limitation of monetary-based indicators, as applied to the stock market lies in the variability of the lead time as related to market reversals.

Good examples of the stock market taking its sweet time to respond to the rule “Do Not Fight the Fed” are the last three shifts in the Fed’s monetary policy. Attempting to slow down “irrational exuberance” in 1999, the Fed started to hike interest rates in August 1999, with the third hike announced in January 2000. It took eight months before the market top was completed. Spooked by the ferocity of the subsequent sell-off, the Fed wasted no time reversing the tightening. By February 2001, it had lowered interest rates three times. But it took another eight cuts before the market finally bottomed out in 2002. The latest switch in monetary policy started with the first quarter-percentage increase in the federal fund rate in July 2004. The third step-up of September 2004 has since been followed by another seven increases and the promise of more of the same in upcoming months.

The stock market’s unhurried response to the Fed’s tightening, so far, is not out of the historical norm. What is unique this time around is the seemingly perverse response of the long-term dated notes and bonds. The yields on treasuries of 10-year or longer durations defied the Fed’s latest tightening and instead declined.

Over the last 25 years, the trend in long-term bonds has correlated closely to the federal fund rates. The high odds of this correlation reasserting itself in 2005 do not bode well for the bond market. Nor will a competition from higher yields on interest bearing securities, ranging from MMFs to long- term bonds, be healthy for the stock market.