Tuesday, July 25, 2006

The Fed Effect

Clearly a number of different factors influence the stock market, but on those days that the Federal Reserve Chairman speaks his remarks tend to be among the most reported news items of the day. The speech, wherever it is, is often broadcast live on radio and television. Access to electronic trading platforms also means that the sentiment of individual investors as well as professional traders is reflected in the stock market even before the Chairman walks away from the podium.

I thought it might be instructive to look at market performance over a period of time to see if the small-cap sector is at all immune from the traders’ immediate reactions to the Fed Chairman's remarks.

The Federal Reserve provides a list of all public appearances by the chairman for the past ten years. (You can also read the
Speech Transcripts, if you are interested or just have a lot of time on your hands.) Using those dates, I looked at price performance on the day of and the next day after in the Dow Jones Industrials (large-cap) and the Russell 2000 (small-cap) indices.

It appears that investors in both large and small companies are prone to overreaction when the Fed Chairman speaks, but the pendulum of the small-cap sector swings wider. There are also differences in the market reaction to the Fed Chairman during expansionary periods compared to the present restrictive policy period, but in this subset the small-cap investor reaction is surprisingly muted compared to the large-cap sector.

You can see the details of our mini-study in the Market Paper, “
Federal Reserve: when the Chairman Speaks.” While our simple calculations lack the rigor to eliminate the effects of the myriad of other factors that influence stock prices, I believe our survey provides some insight into investor reaction to the "Fed Chair" no matter who is sitting in it.

For those interested in a more thorough discussion of U.S. monetary policy, Thomas Havrilsky’s book, The Pressures on American Monetary Policy, might be interesting. This author looks at how the President uses political pressure to influence monetary policy. Havrilsky puts the Fed into a historical perspective and reveals the not-so-objective motivations of legislators who created it.

Investors looking for some tips on how to make money using a monetary policy angle, Unexpected Returns: Understanding Secular Stock Market Cycles is a solid “how to” book. The author, Ed Easterling, turns a pretty phrase considering he starts with the dry subject of interest rates and economic cycles. Yet he does not scrimp on substance. Consequently, Unexpected Returns is a realistic guide for traders.

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