by Martin Zweig
7/26/82
124.39
+61.2
8/10/83
200.53
-3.0
10/15/84
194.61
+56.7
5/1/87
304.87
-24.1
11/5/87
231.53
+7.7
5/11/88
249.35
+19.58
7/14/89
298.17
+26.5
4/19/94
377.33
+18.9
12/20/95
448.50
+7.3 *
$10,000 becomes: $610,554 $2,336
Annualized Return = +18.7% -7.8%
Buy-and-hold return = +6.5% per year
Percentage of signals
correct 90.9% 61.9%
On the buy signals, the S&P went up eighteen times in twenty-two tries, a success rate of 81%. On the sell signals, the S&P 500 Index fell eleven times, stayed even once, and rose nine times. That’s good for a 57% batting average. A $10,000 stake by a “wrong-way” investor would have slipped to $7,676 during the sell modes, a loss of 1.5% per annum.
FED INDICATOR
It’s been said that the Federal Reserve writes the script for the stock market. The evidence supports that theory. The Fed, as it is commonly called, has the job of adjusting the growth of the nation’s money supply, monitoring the trend of credit or borrowings, and influencing the level of interest rates. It does not necessarily tackle all of these tasks at any one time, but whatever goal the Fed has in mind, it is certain to have a major impact on interest rates and ultimately on stock prices.
Among the weapons in the Fed’s arsenal are three potent and overt vehicles, the discount rate, the federal funds rate, and reserve requirements. The discount rate is the interest rate the Fed charges banks that wish to borrow from the Fed’s “discount window.” Such borrowings are made when banks strive to obtain required reserves. The federal funds rate is the interest rate banks can use to borrow from each other. The level of reserve requirements can either liberalize or restrict the ability of banks to make loans.
The Fed has the power both to determine the discount and federal funds rates and to set reserve requirements. When it does so, the news is always prominently displayed in the financial section of major newspapers and usually makes the national news on television. Back in 1974 I developed a model for monetary changes in these guideposts (plus the less effective impact of stock margin requirements) and dubbed it the Fed Indicator. I recently simplified the rules and came up with a better mousetrap.
TABLE 2
PRIME RATE INDICATOR
VS. STANDARD & POOR’S 500 INDEX: 1954 to 1996
BUY SIGNALS SELL SIGNALS
Date
S&P
% Change
Date
S&P
% Change
3/17/54
26.62
+54.8
10/14/55
41.22
0
1/22/58
41.20
+41.1
5/18/59
58.15
-.7
8/23/60
57.75
+54.0
3/10/66
88.96
-3.5
1/26/67
85.81
+11.7
4/19/68
95.85
+6.8
9/25/68
102.36
+5.6
12/2/68
108.12
-24.2
9/21/70
81.91
+21.8
7/6/71
99.76
-4.1
10/20/71
95.65
+12.4
6/26/72
107.48
-10.7
1/29/74
96.01
+1.3
3/22/74
97.27
-24.4
10/21/74
73.50
+20.7
7/28/75
88.69
+.5
11/5/75
89.15
+10.6
6/7/76
98.63
+4.6
8/2/76
103.19
-6.9
5/31/77
96.12
+11.9
12/7/79
107.52
+6.6
2/19/80
114.60
-8.0
5/1/80
105.46
+18.4
8/26/80
124.84
+8.8
12/22/80
135.78
-.5
4/24/81
135.14
-2.2
6/16/81
132.15
-.2
6/22/81
131.95
-11.1
9/21/81
117.24
+.5
2/1/82
117.78
-8.9
3/8/82
107.34
+1.8
3/16/82
109.28
+1.0
7/26/82
110.36
+46.4
8/10/83
161.54
+2.6
10/15/84
165.77
+73.8
5/1/87
288.08
-11.7
11/5/87
254.48
-.5
5/11/88
253.31
+31.0
7/14/89
331.84
+33.4
4/19/94
442.54
+36.9
12/20/95
605.94
+7.3 *
$10,000 becomes: $318,068 $7,676
Armualized Return = +15.5% -1.5%
Buy-and-hold return = +7.9% per year
Percentage of signals
correct 81.8% 57.1%
It’s very easy to keep abreast of the data you will require in order to maintain the Fed Indicator. All you need know is the direction of change in either of the three tools. Between them they’ve only been changed an average of three times a year in the past, so this is truly a “lazy man’s indicator.”
Note:
Since both the discount rate and the federal funds rate serve basically the same function, I now use changes in either rate in the rules for calculating the Fed Indicator and compiling the statistical data for performance. To avoid confusion in the following sections, I refer only to the discount rate. However, you should be aware that this reference also encompasses the federal funds rate since August 1995, when I revised these guideposts.
Rules:
To calculate the Fed Indicator, you must grade the discount rate and the reserve requirements separately. Then their scores are combined. In the following examples, I’ll stick with just the discount rate, but the rules would work exactly the same for reserve requirements. (At this writing, the Fed hasn’t touched reserve requirements since the fall of 1981.)
Negative Points:
An increase in either the discount rate or reserve requirements is bearish (recall: rising interest rates are usually negative for stock prices). A hike in either one receives minus one point for that component of the Fed Indicator. It would also wipe out any positive points that might have been there at the time. The negative point remains for six months, after which it becomes “stale” and is discarded.
Example: Suppose the discount rate were raised on January 1. It would give that element a -1 rating. If no more changes were made by the Fed, the discount rate score would revert to zero on July 1. Alternatively, if a second discount rate hike came on, say, March 1, the score would drop to -2 points. On July 1 the rating would go to -1 as the first move faded. Then on September 1, the second negative point would drop and the score would be zero again. A change i
n the discount rate does not affect the score on reserve requirements, nor vice versa. Here is how the scoring would look in tabular form:
Jan. 1
Rate rises
-1
July 1
(No further changes)
0
Alternatively:
Jan. 1
Rate rises
-1
March 1
Rate rises again
-2
July 1
(No further changes)
-1
Sept. 1
(No further changes)
0
Positive Points:
Moves by the Fed toward easing have a greater positive impact on stock prices than the negative effect created by tightening moves. So, an initial cut in either of the two tools not only wipes out any negative points that may have accumulated, but it also kicks in two positive points. An initial cut is the first one following a rise in that component. Or a cut is initial if it marks the first change in that instrument in at least two years. As an initial change grows stale, one of the two points is lost six months later and the remaining point falls out a year later.
If a second reduction were made in the discount rate, it would add one more point, for a total of three points. That point, resulting from the second cut, would become stale six months later and would drop out. Third, fourth, fifth, or even more consecutive cuts in the rate would be treated the same way.
Example: Suppose that the Fed previously had raised the discount rate one or more times … or that it had not changed it for at least two years. Now, assume that the discount rate were lowered on January 1. It would eliminate all negative points (if any) and add two positive points since this is an initial cut. The discount rate component would stay at +2 for six months. On July 1 it would drop to +1 as the initial move begins to grow stale. The following January I the rating would fall to zero as the initial cut fades away. Here is the scoring in tabular form:
Dec. 31
(Rate unchanged for 2 years)
0
Jan. 1
Rate lowered
+2
July 1
(No change since January)
+1
Jan. 1
(No further changes)
0
Now suppose that after the January 1 initial cut, the Fed slices the discount rate a second time on April 1. That would add one more point, for a score of +3. On July 1 the rating would dip to +2 as the initial cut loses a point. On October 1 the rating would ease to +1 as the secondary cut of April 1 fades away. And, of course, on the following January 1 the last point would drop and the rating would be zero. In tabular form, it looks this way:
Dec. 31
(Rate unchanged for 2 years)
0
Jan. 1
Rate towered
+2
April 1
Rate lowered
+3
July 1
(January 1 cut fades)
+2
Oct. 1
(April 1 cut fades)
+1
Jan. 1
(Final point fades)
0
Calculating the Fed Indicator:
There will be a rating for each of the components, the discount rate and reserve requirements. A move in one has no effect on the other. To calculate the Fed Indicator itself, merely add the scores of the two components. There will rarely be more than three or four points in the discount rate nor more than about two or three in reserve requirements. The Fed Indicator will normally range from -4 to -5 at the worst to about +6 or +7 at the best. However, extensive testing has found that scores below -3 don’t have any greater negative effect on stocks than a -3 rating. Similarly, scores above +3 have no greater positive effect on stocks than a +3 rating. Testing has determined the following gradings on the Fed Indicator:
Extremely Bullish
=
+2 or more points
Neutral
=
0 or+1 point
Moderately Bearish
=
1 or -2 points
Extremely Bearish
=
-3 or more points
There is no “moderately bullish” rating simply because scores of +2 points led to excellent stock market performance, and ratings of +1 point turned in ho-hum returns. There was no point total that consistently coincided with moderately good stock results.
Graph F (pp. 56–57) shows the changes in the discount rate from 1963 through February 29, 1996. Since 1914, when the Fed first regulated it, the discount rate has been hiked 77 times and lowered 83 times (through March, 1996). Reserve requirements, first regulated in 1936, change far less frequently. They have been raised 15 times and dropped 30 times.
From 1914 to 1936 the discount rate was the only device the Fed had. Even so, just that one indicator produced results consistent with those in periods since then. Reserve requirements were introduced in 1936, so I used the sp from then through 1957 to “test” the Fed Indicator, which is how the ratings described above were formed. Once the rules were set, I applied them to the years from 1958 to the present (1996), an era in which institutional trading came to dominate the stock market. The results turned in from 1958 to 1996 did not differ significantly from the earlier days.
I first tested the Fed Indicator’s performance against the Zweig Unweighted Price Index (ZUPI). As seen in table 3, when the Fed eases, stocks take off. A $10,000 investment in the broad market (ZUPI) when the Fed Indicator rated “extremely bullish” would have grown to $190,906 in a cumulative span of only 11.9 years. That’s a whopping annualized return of 28.0%, miles ahead of the 6.4% a year on buy-and-hold. Indeed, the broad market has actually declined 2,5% per annum over the remaining 26.3 years since 1958, when the Fed was anything but “extremely bullish.” The results in the “extremely bullish” zone were very similar from 1936 through 1957, with an annualized gain for the ZUPI of 33.8% vs. only 7.1% for buy-and-hold.
GRAPH F
Ned David Research
TABLE 3
PERFORMANCE OF FED INDICATOR VS. ZWEIG UNWEIGHTED
PRICE INDEX:
January 24, 1958 to March 20,1996
Fed Rating
Total No. of Years
% Cases Market Rose
$10,000 Investment Becomes
Return Per Year
Return vs. Buy-&-Hold.
Extremely Bullish
11.9
88
$190,906
+28.0%
+21.6%
Neutral
13.5
52
10,472
+0.3%
-6.8%
Moderately Bearish
10.1
48
6,756
-3.8%
-10.2%
Extremely Bearish
2.7
30
7,357
-8.1%
-14.5%
Total
38.2
61
$106,980
+6.4%
—
TABLE 4
PERFORMANCE OF FED INDICATOR VS. STANDARD & POOR’S 500 INDEX: January 24, 1958 to March 20, 1996
Fed Rating
Total No. of Years
% Cases Market Rose
$10,000 Investment Becomes
Return Per Year
Return vs. Buy-&-Hold.
Extremely Bullish
11.9
88
$107,262
+22.0%
+14.5%
Neutral
13.5
59
17,002
+4.0%
-3.5%
Moderately Bearish
10.1
48
9,684
-0.3%
-7.8%
Extremely Bearish
2.7
30
8,823
-3.4%
&
nbsp; -10.9%
Total
38.2
65
$158,485
+7.5%
—
During “neutral” periods the ZUPI dipped 0.3% a year, while in the “moderately bearish” zones it fell 3.8% per annum. The “extremely bearish” mode produced losses of 8.1% a year, or 14.5 percentage points worse than buy-and-hold. The market rose only twice in the nine trips it made into the most bearish category.
Table 4 shows the returns of the Fed Indicator against the Standard&Poor’s 500 Index, which is less volatile than the ZUPI. Still, the “extremely bullish” mode showed a nifty 22.0% annualized gain with the S&P rising in fifteen of sixteen cases. That’s 14.5 percentage points superior to buy-and-hold.
The “neutral” range posted a gain of 4.0% a year. The “moderately bearish” region had a loss of 0.3% a year, and the “extremely bearish” rating actually did worse than that, losing 3.4% per annum (but that bottom rating against the ZUPI did much worse than the “moderately bearish” ranking, as ought to be the case).
Table 5 shows what has happened since 1958 in the most potent Fed Indicator zone, “extremely bullish.” Remember, monetary indicators generally have their greatest impact on the bullish side and only moderate impact on the bearish side.
The middle column of table 5 shows that the ZUPI declined only one time out of seventeen trips into the “extremely bullish” region, and that produced only a trivial loss of 1.3% in 1981–82. Then, after a six-week hiatus, the top ranking returned in July 1982, just before the market exploded with its greatest rally in forty-nine years. By May 1983, when the “extremely bullish” rating finally gave way, the ZUPI had gained an extraordinary 64%, its tenth double-digit gain in twelve tries. Indeed, in nine of the sixteen cases the gains for the ZUPI were better than 20%. No wonder I call it “extremely bullish”!
