A simple way to outperform the market – follow the Fed!

Welcome to Finance and Fury.

This episode – be looking at one of the simplest ways to potentially generate alpha and outperform the broader market It’s been a decade since financial markets have become increasingly centrally-planned by central banks and with this - disconnected from fundamentals Hence – traditional analysis of shares based around their fundamentals may not provide outperformance – however – I think it is still important to understand which are good companies to buy into Looking at fundamentals and understanding these and their implications in the broader sense can be hard – takes many years to learn But what if there is an even simpler strategy to beat the market and generate alpha? That is where there is one interesting strategy from some quants – released an article called "Can quants make money by tracking the Fed books?" Runs through trading alongside the Fed's balance sheet – as this seems to be the dominant price setter in markets Been talking about this emergence in a few episodes recently – but interesting that some quant traders are now implementing this Looking at the influence the Fed has had on share prices - Monetary policy has the ability to influence asset prices – a lot of evidence that low interest rates and accompanying expansionary in monetary supply creates rallies in assets with risk - monetary contractions can create market retreats   been more obvious since the GFC - market reactions appear to have become increasingly aligned and dependent on central bank actions – especially that of the Fed This is in part due to policies such as QE – as well as forward guidance from CBs – with statements like to the effect of supporting markets by any means necessary – increasing speculation and the dive head first into those assets that will be supported In 2008 – the total assets on the Fed balance sheet have expanded from $2.3tn to about $7tn today – this is a growth rate of over 200% Over the same time - S&P 500 rose from 900 to about 3,300 -growth of about 270% Over the shorter term – this year specifically – From March the Fed was sitting on about $4.7tn and this has grown to the previously mentioned $7tn figure – a growth of about 48% the S&P 500 over the same period has returned about 42% There is definitely a correlation here – but there is likely a causal relationship as well due to the flow of money into the markets that comes with the Feds balance sheet expanding – injecting liquidity as they would call it But how predictable are asset returns based on prior Fed action and can this be used as a tool to outperform the market? Technically – Fed policies have to be transparent – hence they can be market-moving – if traders are paying attention – so there is likely a first mover advantage here – Looking at what the quants wrote as their trading strategy – or what they are looking at - simply following the Fed They first go through the observation of the correlated movements between markets and the balance sheet of the Fed – have many charts showing the relationship between the growth of the Fed balance sheet and a variety of risk assets They note that the sheer scale of unconventional monetary policy does seem to have also made asset returns more predictable, and performance appears increasingly contingent on central bank actions. This provides a potential opportunity for investors. Fed has committed to maintain its asset purchase programmes “at least at the current pace to sustain smooth market functioning”, and with ultra-low rates expected to at least until 2023, according to the Fed, it is clear these unconventional monetary policies are going to remain a key driver of markets for some time. The quants note introduces a simple tactical alpha strategy that uses the growth of the Fed balance sheet to measure the degree to which monetary expansion is supporting risk-asset rallies The strategy - implemented in the context of the classic long-only equity/cash decision (buying and selling shares) – “provides supportive evidence of market predictability and the potential to utilize measures of unconventional monetary policies in designing systematic strategies” This means that to outperform the market – you can follow the growth of the feds balance sheet – as they note based around their simulations – doing so “generates a sizable outperformance with a reasonable success rate" Important to point out that this model is illustrative - provides a framework to extend to analogous risk -on/-off They did run some observations on if the relationship between the Fed causal beyond what is correlated – presented the correlation of weekly growth in total Fed balance sheet assets with lagged and subsequent returns of the S&P 500 index – what they found: “The negative correlation between lagged stock market performance and current growth in Fed assets (left-hand chart) means that stock market declines increase the likelihood of Fed action in the form of balance sheet expansion. On the other hand, the positive correlation between subsequent stock market performance and current Fed asset growth means that Fed balance sheet expansion leads to positive stock market performance. The impact of Fed asset growth on equity markets lasts, on average, for the subsequent four weeks.” “Consistent with economic priors, balance sheet expansion leads to stronger positive market returns, and our analysis shows that this lasts for up to four weeks, following the policy change, with a peak observed at three weeks. On the other hand, and contrary to expectations, Fed balance sheet contractions are also followed, on average, by market rebounds, although the strength of these correlations were much weaker in the initial three weeks, with a stronger bounce on the four-week mark.” So there appears to be a small announcement effect initially – but then the market reaction appears gradual – peaking at the 4 week mark Could be for a number of reasons – information delay – through to it taking 4 weeks for the liquidity to hit equities – through the purchases being in the Fixed Interest markets and for those on the secondary market to turn around and use the funds to buy shares – or it could be the impact on the lowering costs of capital for companies pushing up the valuations – whatever the reason – there is a lag   Can these observations be traded – this isn’t advice – but general in nature – based around what the evidence shows The Quants design of investment strategy considers the distinctive lead-lag correlations between Fed expansion and Fed contraction – so they designed a weekly tactical alpha strategy based on Fed asset growth that aims to boost investment returns by selectively overweighting riskier assets during Fed monetary expansion regimes. To that end, the quants used weekly Fed balance sheet data over the period of 2009 and Sep. 2020 – a period of intensive use of unconventional monetary policy tools The strategy consists of using a classic equity-cash allocation with the goal of generating excess returns by systematically tilting towards risk opportunistically following expansionary monetary policy In the illustration – they used a long-only portfolio with a strategic allocation of 75/25 between equity and cash – their evidence showed that the impact of Fed asset growth lasts on average for four weeks with the lead-lag correlation to cumulative S&P returns peaking at around the fourth week. The input to the strategy is the weekly growth rate in the Fed total assets, and the strategy seeks to allocate more to equities (from safe asset holdings) during periods of monetary easing as reflected in the growth in Fed assets. the performance of this simple tactical tilting strategy shows that they would have been able to provide annualized excess returns of 2.5% So based around these models – it appears to work – can it continue working? If it is implemented correctly – and assuming that the causal relationship is due to the spill over effects from programs like QE or corporate bond purchases But there is no denying that the Feds movements do now move markets – the quant strategy implemented in the context of a long-only equity/cash portfolio provides some evidence of the potential to utilize the Fed as a partner in generating returns – if they are going to expand the money supply and this is going to flow into risk assets – like shares – why not follow? The Quant simulation generates a sizable outperformance with a reasonable success rate What else should we expect in the financial world where trillions of additional dollars from the expands of the Fed balance sheet have the ability to flow into shares once they are loosed into financial markets This being said - the Fed balance sheet-tracking strategy probably shouldn’t be the sole investment strategy that people use – Important to remember goals and look at your own risk tolerances and the point of investing But it could be useful as an overlay - given the massive numbers of other factors that affect markets and their performances - the Fed balance sheet strategy could also be blended with other trading decisions

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/