Every six to seven weeks, we go through a tense week in the stock market. A bunch of very smart central bankers meet in Washington D.C. to decide on the path of U.S. monetary policy. Just like this week! U.S. monetary policy is determined by an elite group of Federal Reserve officials; the Federal Open Market Committee (FOMC). It has 8 scheduled meetings per year and the schedule is pre-announced for everyone to see. And the meetings are scary for the stock market. If by scary you mean scary profitable!
Research has shown that historically the stock market has done extremely well whenever the FOMC meets. Let’s look at some of the numbers. I gathered data since January 1990 and computed the weekly S&P500 returns. Specifically, I calculate weekly total returns (dividends included) and subtract a risk-free (very short-term T-bill rate calculated per week). Out of the 1,421 weeks, we had 218 weeks with FOMC meetings and 1,203 without. The results are in the table below:
Results:
- During FOMC weeks one would have gathered a staggering 27% annualized compound return, compared to only about 6.5% for the entire period. And that’s in excess of cash!
- The realized risk during FOMC weeks is slightly lower than during other weeks. Nice!
- Quite intriguingly, the compound return during FOMC weeks is higher than the arithmetic average return (26.77% vs. 24.88%). Normally it’s the other way around because it takes an 11.11% gain to recover from a 10% loss. The explanation is that during FOMC weeks, returns have positive skewness. So, FOMC weeks offer the stock return “Holy Trinity”: High Return, Low Risk, Positive Skewness! Amazing!
- Non-FOMC weeks have the opposite characteristics: They have lower returns than the average, higher risk and lower (more negative) skewness.
- Drilling down further into non-FOMC weeks, it appears that the pre-FOMC week and especially the post-FOMC weeks have weaker average returns. It must be that after the FOMC euphoria we suffer a bit of a hangover!
Cumulative returns
How would a portfolio have performed if we had been invested only during specific weeks (and held cash during the other weeks)? In the chart below, I plot the cumulative return of the S&P500 over all weeks (black line) and FOMC weeks and various non-FOMC weeks (mutually exclusive and exhaustive). Quite amazingly, we garnered the majority of equity returns simply during the 218 weeks with FOMC meetings. Pre-FOMC and post-FOMC are just flat lines and the “all others” weeks underperform the FOMC weeks even though there were 767 such weeks (3.5 the number of FOMC weeks). And it even gets better: during FOMC weeks you actually made money during the volatile 2001 or 2008/9 periods, while during the non-FOMC weeks you were exposed to all the nasty volatility during the recessions. How amazing is that?
Other research, based on daily and intra-day data
OK, I admit I’m not the first to find this effect. This FOMC effect has been pretty well-known in finance circles for a while. For example, researchers at the New York Fed have drilled down even more into this FOMC effect and looked at daily and even intra-day data. They found that the roughly 0.5% average return per FOMC week is mostly due to the actual FOMC day and the days right before and after. Quite intriguingly, the excess return happens mostly before (!) the FOMC announcement!
Update (5/4/2017): Murphy’s Law of blogging struck again! The S&P500 was actually down on the FOMC decision day (Wednesday, 5/3). But weekly return still has hope to come in above zero, so stay tuned!!!
There are no sensible explanations for the “FOMC effect”
- Coincidence? Could this just be a fluke? Not likely. The outperformance of this FOMC drift is statistically significant. I ran some tests on the weekly numbers above to confirm that, and the NY Fed wrote a whole detailed 63-page research paper and found that this effect is highly statistically significant.
- Higher risk = higher return? Not likely! First of all, the realized risk during the FOMC week is actually lower, see our table above. It is true, though, that the implied volatility index (VIX) is marginally higher before the FOMC meeting. But that small difference would not justify the outsized excess returns during the FOMC week.
- Relief Rally? One theory I had was that before each FOMC meeting there is a small probability of a black swan event; everybody has the concern that the FOMC could “blow up the economy” with a policy mistake. When that doesn’t happen a relief rally ensues. But that theory is negated by the FOMC drift before the announcement according to the NY Fed study. Unless, of course, and now we have to go to a full-blown conspiracy theory, somebody inside the meeting room leaks information to his/her Hedge Fund friends. True, there have been leaks before, but it would be unthinkable that this could go on unnoticed for decades.
So, to be honest: There is no good explanation for this. If anyone has a good theory, please share below!
Will this still work when the FOMC raises rates?
If you are not intrigued by now, how about this: the FOMC effect works regardless of the policy decision of the FOMC. There are some slight differences depending on whether the FOMC raised rates, lowered rates or left the rate unchanged, but they don’t appear statistically significant. In fact, some of the best FOMC week returns occurred during the late 1990s (rate hikes) and 2013/14 (tapering), i.e., during monetary tightening.
How to profit from this effect?
Very easy: Load up on equity futures the Friday before the FOMC week, sell everything on the Friday after the FOMC! But I would strongly advise against actively trading this. This is now a well-known (though not well-understood) phenomenon. I wouldn’t be surprised if some hedge funds are already betting on this, which would eventually diminish this profit opportunity. What I can recommend, though, is to not be a sucker; if you intentionally or unintentionally bet against this phenomenon you’ll likely lose money. I have often caught myself wondering if I should derisk ahead of the FOMC meeting. Fight those lizard brain instincts! Our blogging friend Physician on FIRE had a nice post “Don’t just do something. Stand there!” on the topic of not overreacting to sudden market moves. For the FOMC weeks, it’s even easier not to overreact because the dates are known a year in advance. Tie your hands, tie yourself to the mast like Ulysses and resist the temptation to derisk. Especially this year there will be some uncertainty surrounding the FOMC meetings regarding the timing of additional rate hikes and the “balance sheet normalization.” So, I would follow the simple rules below:
- Don’t derisk ahead of the FOMC meeting for fear of market volatility. FOMC weeks are some of the best weeks for the stock market.
- If we have a large lump-sum to invest in stocks, we try to invest before the FOMC meeting, if possible.
- If we are taking out money from stocks, we try to wait until after the FOMC meeting, if possible.
We hope you enjoyed today’s post. Please leave your comments and suggestions below. And stay profitable everybody!!!
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