Why the Fed doesn't matter

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How many headlines have you seen in the past week or two that went something like this: "Investors eagerly await Fed decision," "Wall Street pauses before Fed meeting" or even "Dow higher on Fed rate-cut hopes"?

Unless you've been living under a rock, probably dozens. Around the world, investors have been hanging on every word the Federal Open Market Committee, the Fed's rate-making body, has to offer. Their goal has been to try to figure out whether the central bank will be able to stave off a U.S. recession -- and whether they should jump into or out of the stock market.

This, of course, isn't new. Just about every time the FOMC meets, analysts and the media pore over its announcements, and then, when they are released three weeks later, dissect every sentence of the FOMC minutes in search of clues on what the committee members are thinking. Given all of this attention, you'd think that the best investors would be particularly tuned in to the Fed's actions. After all, great investors -- say, Warren Buffett -- must have the ability to read between the monetary policy lines and take advantage of the Fed's actions, right?

Well, in many cases, wrong.

Consider what Buffett had to say back in September, when the Fed began this four-month run of interest-rate cuts: "I don't care," he told CNBC. "I don't think it makes any difference whatsoever to an investor in stocks what (the Fed does) today. I would not change a buy or a sell order that I have in."

Stocks in good companies are more important

To Buffett -- and to many great investors -- the key to investing is focusing on good companies whose stocks are being sold at reasonable prices. "Anybody that is buying or selling stocks based on what the Fed is doing, or what they think they're going to do at their next meeting, I think is destined to not having a great financial future," he said in that September interview.

"It really doesn't have anything to do with the value of good companies three, five years from now. People who think they can dance in and out based on Fed signals, I think, they're going to make their brokers rich, but they're not going to make themselves rich."

I agree with Buffett, and there's ample evidence showing that anyone who thinks he can dance in and out of the market -- whether his decision is based on Fed signals or some other trigger -- won't make himself rich.

Market timers end up losing money

In a 2004 report that studied 20 years of market history, Dalbar, a financial research firm, concluded that mutual fund investors who tried to time the market lost an average of 3.29% per year, far below the Standard & Poor's 500 Index's ($INX) 12.98% annual gain during that time. (Dalbar based those findings on an examination of flows into and out of mutual funds.)

In addition to general market-timing problems, the idea of basing your stock purchases on interest rates has a more specific problem: The approach doesn't offer much guidance in terms of a plan for picking individual stocks.

True, some industries or sectors -- such as financials and consumer stocks -- do tend to do better when rates are falling and cash is easier to get. But interest rates are just one factor impacting these stocks. So, it is by no means a hard and fast rule that financials, say, will gain when rates go down.

Take the Fed's cuts over the past four and a half months. These came on Sept. 18, Oct. 31, Dec. 11, Jan. 22 and Jan. 30.

I recently looked at a sampling of stocks in interest-rate-sensitive industries -- banks, insurance companies, investment firms -- to see how their prices moved in the days leading up to and following those rate cuts. What I found appears to offer little help in trying to draw any conclusions about the short-term impact of rate cuts on stock prices.

In some cases, the stocks generally (though not without exception) rose the day of a rate cut; in other cases, they tended to drop.

If you went out a few days after the cuts, the movements were equally unpredictable. And that should come as no surprise.

Good returns half the time isn't good enough

Of course, all of this is not to say that lower interest rates aren't good for stocks in general. In fact, another study -- this one detailed in the Financial Analysts Journal in 2005 -- shows that from mid-1963 to early 2001, stocks gained an average of 21.86% during "expansive periods" (those when the Fed was relaxing interest rates) but just 2.84% during "restrictive periods" (those when the Fed was raising rates).

Martin Zweig, one of the Wall Street greats upon whom I base one of my "Guru Strategy" computer models, also developed a method for buying stocks when the prime rate (which is related to but not the same as the federal funds rate we've been hearing about) was favorable, and selling when it was unfavorable. According to Zweig, during the times when his prime rate indicator gave a "buy" signal in the 30 years from 1954 to 1984, the S&P 500 increased by an annual rate of more than 17%; when the indicator gave a "sell" signal, the S&P dropped almost 5%.

Continued: The key Cornerstone Growth Factors

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