Some time ago, I came across a book “Follow the Fed to Investment Success: The Effortless Strategy for Beating Wall Street” by Doug Roberts. The book is a very quick read because there is only one main concept. The idea is interesting, though I would have preferred if the book is made much more concise.
I wrote a quick summary of the basic strategy below. Doug highlighted in his book that he has developed more advanced versions of the strategies taking into account other factors that affect or determine of relative performance of large caps versus small caps. The advanced strategies are available, of course, for a fee. The book also has a website here.
- Buy small-caps when real interest rates (nominal interest rate minus inflation rate) are negative
- Buy large-caps when real interest rates are positive.
- When real interest rates are negative, it means that the Fed is pursuing a loose monetary policy, which will benefit small caps more than large caps.
- Conversely, a tight monetary policy favours large caps over small caps.
- A loose monetary policy benefits small caps because it allows them to borrow money to expand and thrive, whereas a tight monetary policy significantly impacts a small cap’s business’ vaibility, which benefits the large caps which can more likely make it through.
- Doug back-tested the strategy from 1928 and found that it beats the S&P by 3% which is higher than the historical small-cap outperformance of 2.5%.
- First, calculate a 12-month moving average of the nominal Treasury bill rate by using the last 12 months’ values of the yield of the 1-month Treasury bill. Basically take each of the 12 yields, divide by 12 (to convert it into a monthly rate), add 1, multiply them together, and minus 1. i.e. T-Bill moving average = [(1 + yield 11 months ago / 12) * (1 + yield 10 months ago / 12) * … (1 + yield today / 12)] – 1. Note that this result is an annual rate.
- Next calculate month-to-month change (in %) of the CPI-U (or CPI for all urban consumers – all items, not seasonally adjusted). Again to get the annual figure, add 1 to each of the 12 monthly figures, multiply them together, and minus 1. i.e. Inflation moving average = [(1 + % change in CPI-U from 12 months ago to 11 months ago) * (1 + % change in CPI-U from 11 months ago to 10 months ago) * …. * (1+ % change in CPI-U from 1 month ago to value today)] – 1. Again note that this result is an annual figure.
- Now the real interest rate estimate = T-Bill moving average – Inflation moving average.
- To account for time lag in the Government’s inflation calculations and time for the changes to flow through the system, you would use the real interest rate figure for 3 months ago to determine whether to go into large caps or small caps. For example, you would decide in June, by looking at the real interest rate as of 3 months ago (March). That real interest rate is calculated using figures from April last year to the March just past for the T-bill, and from March last year to the March just past for the CPI-U (one extra month because of the need to calculate month-to-month growth rate).
- After buying, monitor every month. If there is no change in the signal, do nothing, else switch appropriately.
- In terms of implementation vehicles, two ETFs were suggested: the iShares S&P SmallCap 600 Index Fund (IJR) and the iShares Russell 2000 Index Fund (IWM).