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What the Market’s Unrequited Love for the Fed Means for Your Portfolio

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Tuesday, 17 Jul 2012 08:37 AM Current | Bio | Archive

The secret is out: Markets really are manipulated. A study released by the Federal Reserve Bank of New York last week showed that the stock market has the tendency to rise in the 24-hour period before Federal Reserve statements.

Essentially, the market has been taught, like a salivating dog, to rise in anticipation of Fed comments.

This Pavlovian response, according to the study, is cumulatively responsible for half of the gains of the stock market since the mid-1990s. Without Fed announcements, the S&P 500 would theoretically trade closer to 600 rather than its current level of 1,350.

This begs the question: Why would the market rise in anticipation of Fed comments anyway? Throughout the mid-1990s, as well as in the mid-2000s, the Fed was raising interest rates, which typically puts a damper on the stock market over the short term, because it makes fixed-income investments more competitive.

Well, the answer is simple. It started with the “Greenspan put.” Following the 1987 stock market crash, then-Fed Chairman Alan Greenspan came out saying that the central bank would provide liquidity as needed to prevent a crisis.

Greenspan would continue to harp on this line, and deliver, when necessary. Greenspan kept rates low for too long in the 1990s when the economy was expanding rapidly. Despite the occasional warnings of “irrational exuberance,” Greenspan did little to stop bubbles from forming. Instead, the market was taught that it could expect help from the Fed.

Flash forward to today. Current Fed Chairman Ben Bernanke has continued Greenspan’s polices and left him in the dust with programs like quantitative easing and Operation Twist.

To some investors, this may seem like a positive development. After all, who doesn’t want their stocks to be twice as high? Well, for value investors, high prices are an anathema. Lower prices are better, since it means being able to buy companies at lower valuations and get paid higher dividend yields.

What are today’s investors to do? If markets are trained to rise every time the Fed is set to release new data (as it is later this week), the first thing to do is find quality companies that are trading at or lower than they were in the 1990s on a valuation basis, not a price basis.

The Coca-Cola Co. (KO), for example, traded in the high $80s at its peak in the late 1990s. It trades near there today. At one point in the late 1990s, Coke’s price-earnings ratio (PE) rose above 80. Today it trades at 20. More importantly, the quarterly dividend has grown from $0.16 per share in 1999 to $0.51 per share today — a 219 percent increase.

Dozens of other companies are dominant in their industry like Coke is. Buy them when they’re cheap, re-invest the dividends and your returns will likely beat the market over the long term.

Best of all, unlike interest rates set by the Fed, which can go up or down, quality companies deliver dividend increases year after year like clockwork.


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2012-37-17
Tuesday, 17 Jul 2012 08:37 AM
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