which displays the return on the S&P 500 Index from the beginning of
the month after the fed funds rate has been changed to a date 3, 6, 9, and
12 months later.
The effects of Fed actions on stock prices are dramatic: following in-
creases in the fed funds rate, the subsequent returns on stocks are signif-
icantly less than average; when the fed funds rate is decreased, stock
returns are significantly higher than average. Since 1955, the total return
on stocks has been 7.5 percent in the 12 months following the 112 in-
creases in the fed funds rate, while it has been 15.3 percent following the
108 times the fed funds rate has been reduced. This compares to an av-
erage 12-month return over the period of 11.8 percent. If these results
persist in the future, investors could significantly beat a buy-and-hold
strategy by increasing their stock holdings when the Fed is easing credit
conditions and reducing stocks when the Fed is tightening.
But this may not be the case. Although this strategy has worked
well from the 1950s through the 1990s, since 2000, the impact of Fed rate
changes on the stock market has been the absolute opposite of the his-
torical record. The market has experienced negative returns following
interest rate decreases and positive returns after increases.
This is what has happened. To slow the rate of increasing inflation,
the Fed initiated a series of rate hikes in June 1999 that extended through
May 2000. But the stock market ignored these increases, and it did not
start falling in earnest until September 2001, more than 15 months after
the Fed began raising rates. As the economy suddenly slowed, the Fed
began easing in January 2001, but the market continued downward and
didn’t bottom until October 2002. The Fed eased a final 25 basis points
(bps) in June 2003, to reach a 50-year low of 1 percent, which it main-
tained for one year.
The market moved upward strongly in 2003, but in June 2004, as
the economy was recovering, the Fed began the first of 17 consecutive^1 ⁄ 4 -
point increases that ended in the summer of 2006. Despite these in-
creases, stocks continued to rise. Buying when the Fed begins to ease
and selling when they start to tighten has been a poorly performing
strategy over the past decade.
There could be a number of reasons why stocks are not reacting to
Fed rate movements as they have in the past. Perhaps investors have be-
come so geared to watching and anticipating Fed policy that the effect of
its tightening and easing is already discounted in the market so that the
impact of Fed actions extend over a period of a few days rather than
over several months. If investors expect the Fed to do the right thing to
stabilize the economy, this will be built into stock prices far before the
198 PART 3 How the Economic Environment Impacts Stocks