Whether or Not to Heed the Fed

Times Staff Writer

The stock market is off to a flying start this year, but anyone who’s still afraid of committing to equities or bonds has a handy excuse: The Federal Reserve says investing is a bad idea.

How so? The central bank, by raising short-term interest rates to 4.25% from 1% over the last 18 months, is sending a message that investors ought to be taking on less risk.

Certainly, that’s the Fed’s goal with regard to the still-hot housing market. As for other investments, the warning is implicit: By raising the risk-free rate of return -- the yield on cash investments such as money market funds -- the Fed is reducing the appeal of going out on a limb to earn higher returns.


The message from Chairman Alan Greenspan and cohorts was exactly the opposite in June 2003, when they cut their benchmark rate from 1.25% to 1%, the lowest in a generation. They were desperate to keep the economy in recovery mode, and one way to do that was to prod investors to take on more risk via purchases of stocks and bonds, thus supplying growth capital to domestic and foreign companies.

It would have been smart to heed the Fed back then. An investment in the blue-chip Standard & Poor’s 500 index at the end of June 2003 would be up about 37% now. The Mexican stock market is up 165% in the same period. You could have locked in a yield of 8.66% on the average corporate junk bond in June 2003, compared with about 7.5% today.

The Fed also was happy in 2003 to stoke home refinancings that kept consumers flush with spending money.

But with the financial and housing markets’ appreciation since mid-2003, and with cash accounts paying the most in nearly five years, some nervous investors believe that it’s difficult to justify paying current prices for stocks, bonds, real estate and many other assets because the returns they might generate in the next few years aren’t compelling compared with what cash pays.

The so-called risk premium -- the reward for holding a risky investment over risk-free cash -- isn’t there, some say.

“Our five-year forecasts show that most asset [classes] are expected to earn very little over cash,” says Gordon Fowler Jr., chief investment officer at Glenmede Trust Co. in Philadelphia.

Of course, that’s a judgment call that is dependent in part on estimates of such variables as future corporate earnings growth and inflation.

Yet Greenspan himself has marveled at how little risk investors seem to think they’re taking in stocks and bonds at these prices and yields. Because volatility in stock and bond markets has declined sharply over the last two years, people may be figuring that that relative calm will endure forever, Greenspan said in congressional testimony in July.

One gauge of expected stock market volatility (and therefore of expected risk) is the VIX index, short for volatility index. It measures investors’ use of “put” and “call” options on the S&P; 500 index.

A VIX reading above 30 means investors are rushing to buy put contracts as a way to hedge against a falling market. A reading under 15 means investors generally are sanguine about the market and don’t believe they have a lot to lose by staying in stocks.

The VIX has plummeted from a reading of nearly 35 in January 2003 to 11 as of Friday. It has been crawling along near that historically low level for most of the last month.

So if you believe the VIX, investors don’t see significant risk in the stock market.

Greenspan, in his July testimony, had a warning for people who were confident extrapolating the recent past far into the future. “History cautions that long periods of relative [market] stability often engender unrealistic expectations of its permanence,” he said.

Stock market bulls have a counter to Greenspan’s warning: The Fed was right to caution about risk taking while it was raising interest rates, they say, but it’s a whole new ballgame once the Fed is done.

The central bank last week gave another sign that it was, indeed, almost done: The minutes of the Fed’s Dec. 13 meeting, released after the usual three-week delay, showed that policymakers believed that the number of additional rate increases “probably would not be large.”

The next central bank gathering is scheduled for Jan. 31.

The Fed minutes last week were enough to jump-start the stock market, which had stumbled in the final week of 2005. It helped that the government’s report Friday on December employment showed a meager net gain of 108,000 jobs for the month, which just reinforced the idea that the Fed soon would call it quits.

Leading the market for the week was the stock sector that often is associated with the greatest volatility (risk by any other name): technology. The so-called SOX semiconductor stock index, which had gained 10.7% in all of 2005, surged 8.4% last week. The Nasdaq telecom-stock index rose 7.3% for the week after losing 7.2% last year.

Another noteworthy statistic: The S&P; 500 gained almost 3% for the week, racking up in four sessions what it achieved in all of 2005.

Investors have long been conditioned to associate Fed rate peaks with stock market rallies. But is that myth or reality?

Unfortunately for both the bulls and the bears, the recent historical evidence is split.

Michael Panzner, head of trading at Rabo Securities in New York, took a look at the performance of the S&P; 500 index in the 12 months following each Fed rate peak since 1980. The S&P; was higher a year after the peaks of 1984, 1989 and 1995 (the index was up 12.7%, 12.9% and 35.7%, respectively). But it was lower a year after the peaks of 1981, 1987 and 2000 (down 9.3%, 16.1% and 12.4%).

Not surprisingly, the market’s trend mainly hinged on what happened with the economy. The Fed’s credit tightening helped to trigger recessions in 1982 and 2001. By contrast, the economy enjoyed “soft landings” after the rate peaks of 1984 and 1995. (As for the 1987 and 1989 rate peaks: Stocks crashed late in 1987 but the economy continued to grow; after the 1989 rate peak the economy was holding up a year later, until a bear market and recession were triggered by Iraq’s 1990 invasion of Kuwait.)

So if you believe that the economy runs a high likelihood of recession this year, history supports the idea that buying stocks may be excessively risky.

If, however, you see a soft landing, the risk of being out of the U.S. stock market would seem to be greater than the risk of being in, even with cash returns better than they’ve been in nearly five years.


Tom Petruno can be reached at For recent columns on the Web, visit



Fast start for stocks

Wall Street rallied sharply in the first week of the year and technology stocks were among the biggest winners - suggesting that investors have a bullish outlook for the economy.

Price gains in key indexes last week

SOX semiconductor +8.4%

Interactive Week Internet +7.3

Nasdaq telecom +7.3

Nasdaq computer +6.1

NYSE energy +5.9

Nasdaq composite +4.6

Russell 2,000 (small stock) +3.9

S&P; 500 +3.0

Dow industrials +2.3

Source: Bloomberg News