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7/23/2008
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Monetary conditions have an enormous influence over stock prices. The trend in interest rates and Federal Reserve policy is probably the single most important factor effecting prices in the stock market. An accommodative policy usually means stock prices will benefit. A rising trend in interest rates is generally bearish for stocks. Therefore, I have designed a list of indicators that determine the major trends in Federal Reserve monetary policy. Interest rates, changes in money supply growth, inflationary expectations, and valuation of bond yields relative to stock yields are the key data that we follow.
The Prime Rate is the interest rate that commercial banks charge their prime or most credit worthy customers, generally the large corporations. The prime rate indicator is a composite indicator that not only assesses the year to year change in the prime interest rate but also the absolute change in the level of the current rate to past values. As a stand alone trading system this Prime Rate Indicator would be a very profitable system as illustrated in Table 1. In almost, 50 years of data on the S&P 500, the annual rate of return was greater than 18%; the downside to this trading system is the potential for 40% plus draw downs to one’s capital. Nonetheless, this simple system outperformed the S&P500 by a factor of 10 over the last 50 years! There are two things to take away from this study. One, we want the Prime Rate Indicator to be in our favor, and two, we can definitely define a better a trading system that utilizes this indicator along with specific entries and exits to minimize the draw downs and maximize the gains. This system is the Prime Rate plus Price Structure Analysis Trading System.
The Prime Rate plus Price Structure Analysis Trading System is a long only system that takes a position in the S&P500 when the Prime Rate Indicator is favorable and when the Price Structure Analysis indicator of price action turns positive. Positions are liquidated with either a 6% stop loss or when the Relative Strength indicator, which is a derivation of the Price Structure Analysis Indicator, turns negative. The results of the Prime Rate plus Price Structure Analysis Trading System are shown in Table 2. While the results are not as great as the Prime Rate Indicator System, the draw down to the Prime Rate plus Price Structure Analysis Trading System is only a very modest 10% of the gross profit versus an almost 50% draw down for the Prime Rate Indicator System. The Prime Rate plus Price Structure Analysis Trading System is a low risk, high reward, stable trading system.
The day to day movements of interest rates, as reflected in short term treasury bills and long term bonds, is an early gauge as to possible interventions by the Federal Reserve. In general, as interest rates fall stock prices will rise. To monitor the direction of short term interest rates, I follow the yield on the 3 month Treasury bill. The indicator I use is a composite indicator that not only measures the year to year percentage change but also the absolute level of the current value relative to past values. As a stand alone trading system this Short Term Interest Rate Indicator would be a very profitable system as illustrated in Table 3. In almost, 50 years of data on the S&P 500, the annual rate of return was greater than 18%; the downside to this trading system is the potential for 40% plus draw downs to one’s capital. Nonetheless, this simple system outperformed the S&P500 by a factor of 4 over the last 50 years!
Once again the importance of having the winds of the Federal Reserve in your investing sails is demonstrated. Using this information as a back drop, we can develop a trading system that minimizes the draw downs and maximizes the gains. In this trading system, I combine the backdrop of favorable short term interest rates (either neutral or bullish mode) with Price Structure Analysis to maximize the entry and exit efficiency. This trading system is the Short Term Interest Rate plus Price Structure Analysis Trading System. Results for this trading system are shown in Table 4. A stop loss of 5% was utilized. The addition of a money management stop loss and the Price Structure Analysis indicator to make the entry and exit process more efficient improves upon the original concept of being in the market when short term interest rates are favorable. As seen in the almost 5 fold increase in the Rina Index, this system spends 30% less time in the market and has a smaller draw down, yet it produces superior annual rate of returns. The Short Term Interest Rate plus Price Structure Analysis Trading System is a low risk, high reward, stable trading system. I follow the yield on long term bonds as they are quick to detect changes in the inflation picture. Being long term, these yields carry the largest inflation premium as investors need to be compensated for the effect that inflation will have in eroding the purchasing power of their future cash flows. To evaluate the direction of the yield on the long term Treasury bond, I use a rate of change indicator that compares the current rate to various rates over the past year. This indicator has four modes: very bullish, bullish, very bearish, and bearish. The results of each signal are shown in Table 5. Table 5.
As short term interest rates approach the level of long term rates, the yield curve is described as flat; an inverted yield curve is when short term rates are greater than long term rates. The yield curve that I analyze and monitor is the yield on the long term bond divided by the yield on the 3 month Treasury bill. While this indicator is in bullish mode 76% of the time, it is probably more important to know when the yield curve is flat or inverted. Under these conditions, the Federal Reserve policy is not accommodative and the markets are expecting economic weakness. Table 6 shows the results of a simple trading system that goes long the market when this indicator is in bullish and bearish mode. While we can refine the bullish mode with more efficient entries and exits to minimize the draw down to our account, it should clear you do not want to be long the stock market when the yield curve is flat or inverted. I have developed an interest rate super indicator that looks at the rate of change of short and long term interest rates as well as the yield curve or spread between the short and long term yield. The results of a trading system utilizing this interest rate super indicator are shown in Table 7.
M3 Money Supply The M3 Money Supply is a broad measure of money and is an estimate of the entire supply of money within the economy. Under the policies of the Federal Reserve over the last 20 years, M3 money supply has shown a consistent and persistent expansion. The indicator that is used measures the rate of change of the M3 money supply and compares it to values over the past year. In addition, absolute levels are also monitored. Price Structure Analysis is then applied to this indicator to determine if the trend in M3 money supply is up or down. When the trend is rising the increased liquidity is beneficial for stocks. The results of a short and long trading system that utilizes the trend in M3 for entries and exits is shown in Table 9.
This system does not use any specific entry or exit strategies or money management techniques, and yet it is still very profitable especially from the long side. Unfortunately, it is prone to a rare 40% draw down to one’s trading capital, so nothing is full proof. Nonetheless, this basic concept of always being in sync with the trend in the M3 Money Supply can be improved upon through the application of money management strategies. From the long side, a 7% stop loss will be applied to the above trading system, and the results are shown in Table 10. Comparing the results from Table 10 to Table 9, it should be apparent how taking a simple concept of following the trend in M3 Money Supply plus money management can yield a very powerful trading model.
However, the analysis of M3 Money Supply isn’t done yet. During oversold extremes in the stock market, there appears to be a link between falling prices and a rising M3 Money Supply. In other words, increasing liquidity in the systems appears to act as a buffer to and provides support to falling prices. See the article in commentary archives entitled “More M3 Money Supply – When Indicators Fail”. The concept for this trading system is to look at what happens to M3 Money Supply during an oversold market extreme. If the trend in M3 Money Supply changes to up or if it is already trending higher during the sell off a long position is initiated. Positions are liquidated either when the 6% stop loss is elected or when the price crosses below the 100 day moving average at a time when the M3 Money Supply is trending lower. The results of this long only system are shown in Table 11. 
The importance of inflation and its effect on interest rates and Federal Reserve policy cannot be understated. To measure inflation, I monitor a 26 week rate of change in the consumer price index. This indicator is then wrapped within adaptive trading bands that seek to determine extremes in the indicator. Constructing the indicator in this manner allows us to determine various modes in the indicator and the data. With regards to inflationary pressures on the impact on stock prices the indicator can be very bullish, bullish, bearish or very bearish. As seen in Table 12, this simple indicator has served as a good guide in determining when the stock market winds are in your investing sails. Table 12.
CRB Futures Index An expanding economy requires raw materials. As the economy heats up so do prices in raw materials. This price inflation can be measured with a 26 week rate of change in Commodity Research Bureau Futures Index. Rising momentum in the CRB leads to inflationary pressures. This indicator has 3 modes. When inflationary expectations are high the outlook for stocks is bearish; the reverse situation is a low inflationary environment as being good for stock prices; there also is a neutral mode to this indicator. Table 13 shows the returns obtained if one had invested in the stock market at the time the indicator was in each of the three modes. Table 13.
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