The late Dr. Martin Zweig, my former boss and mentor with whom I worked with for nearly 20 years, is largely credited for coining the phrase “Don’t fight the Fed.” In his 1970 book Winning on Wall Street he talks about the importance of monetary policy to stock market returns, particularly the trend in interest rates and specifically the Federal Reserve either tightening or easing the Fed Funds rates. To make investment decisions, we used a quantitative model Marty developed that was roughly 60% “Monetary Conditions” which included a combination of various interest rates to determine our level of investment in stocks versus cash. However, before his passing in 2013, he and I had many conversations about what had changed as a result of quantitative easing and the relationship between interest rates and equity returns. With the announcement by the Fed that they will “do whatever it takes” many market participants took that as a signal to buy stocks. Indeed, the market surged on the news, and I had several friends and former colleagues call or text me and ask if this was a perfect set up of “Don’t fight the Fed.” Unfortunately, the reality is much murkier and the reason why the Zweig model also had “Sentiment” (a measure of investors’ level of “bullish” or “bearish” compared to long-term averages) and “Momentum” (“Don’t fight the tape” or “the trend is your friend”) factors built into the other 40% of the model.
Let’s look at a couple things the Fed is doing to support the economy, and by proxy the markets.
The above chart is the total assets held by the Fed, which had been in very stable growth before the 2008 decision by the Federal Reserve to begin what is now known as “quantitative easing,” or QE- at which point it surged. As is abundantly obvious by this chart, the Fed just did a massive new round of QE taking their total holdings $6 trillion (yes, trillions of dollars), dwarfing all previous records. A brief cautionary thought: even though the Fed began the first QE experiment in September of 2008, and continued purchases in earnest through December 2008, the market didn’t bottom until March of 2009. In retrospect, still a good entry point, but that next leg down to the 666 low of the S&P 500 in early March was very painful for those who jumped the gun and put all their cash to work.
Another way of looking at the Federal Reserve economic support is how much they are increasing money supply. This is exactly what Milton Friedman, the Godfather of the Monetarist school of economic thought, would recommend. In the above chart we can see that the Fed is aggressively pumping M2, anticipating the coming recession that is widely expected as a result of forced business shutdowns and quarantine. Both the increase in money supply and the massive purchases of securities are unprecedented in scale and scope, thus the Fed truly is doing “whatever it takes,” at least the economic levers they can control.
However, Marty was an advocate of a gradual and incremental approach to increasing or decreasing exposure to the market. He liked to say “slow and steady wins the race,” and our neutral position, when the model had conflicting signals, was 70% in stocks and 30% in cash. He believed, as I do, that having a certain amount of cash to deploy when things look particularly compelling is a wise investment strategy. In periods of extreme volatility in the market, and in this case the extraordinarily rapid snap back from recent lows, Marty tended to be cautious. Although sadly I cannot pick up the phone and ask my old friend his opinion on the markets, I believe he would stick to his model and discipline and maybe only add incremental cash to this market- if he hadn’t already when the sentiment measures became extremely bearish two weeks ago. During the 2008-09 financial crisis, Marty relayed a story to me that he realized he was too early in returning to the market in 2000 when the Fed first eased, as the market didn’t bottom until 2001. He believed, as all great investors do, “when the facts change, so do my opinions” and he learned that the first move up in a bear market, even with early Fed action, commonly fails. With the exception of the Crash of ‘87 (which Marty and his model correctly predicted, and he famously called on Wall $treet Week with Louis Rukeyser the Friday before the crash), bear markets are rarely a “V” bottom and usually have several bear market rallies that ultimately fail. We may possibly have made the lows here, but unless you think that this government mandated shut down of businesses due to the Covid-19 virus will quickly be remediated, caution is still warranted, notwithstanding the Federal Reserve support. While the former Zweig Model likely improved with the combination of: 1. A cut in the Fed Funds rate, 2. A decline in bond yields, and 3. The increase in money supply, it is not all systems go and a “put all your cash to work” kind of market.
At PortfolioWise, we would focus any new investment in areas of the market that show relative strength and fit your overall tolerance for risk. In yesterday’s blog, my colleague Pete Carmasino focused on Technology, Communications, Healthcare, Utilities and Staples as areas that our ETF ratings have more favorable readings. For advisors who want to use this broader decline to put long-term money to work, and not “Fight the Fed,” these are the areas that look most compelling. I bet Marty would agree.