Protect Your Portfolio From the Fed… No Matter What It Does Next

Federal Reserve actions have had an impact on market prices and lately I’ve heard some traders blame the Fed when their performance suffers. However, a well-designed trading system should be able to take advantage of Fed action rather than be derailed by their policy changes.

Although the size of the intervention in recent years is unprecedented, the Federal Reserve has now been influencing market prices since it was established 100 years ago. In response to the financial crisis in 2008, the Fed adopted a variety of quantitative easing (QE) programs that have pushed interest rates down and possibly pushed stock prices up. Current policies will continue providing more than $1 trillion a year until the economic recovery can be sustained without QE.

This is in contrast to what the Fed did after the 1929 financial crisis. A study by Federal Reserve Bank of San Francisco economists concluded that Fed tight money policies in 1930 decreased both economic activity and stock prices.

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These two episodes, 2008 and 1929, may be the greatest economic challenges the Fed has faced. Economists can debate questions about how effective either policy was, but traders can be content simply understanding that the Fed has an impact on markets. Whether the Fed is managing QE or raising interest rates, market prices are reacting to this and every other macroeconomic variable contributing to an economic expansion or contraction.

Trading system developers accept the fact that prices respond to variables. Because we trade prices rather than policies, the system should look at price and traders could completely ignore economic factors. This is the general idea behind my 26-week rate of change (ROC) system. I developed this system before the Fed began experimenting with QE and my system has continued working well through the financial collapse and recovery.

Bonds might have been the market most affected by QE programs as the Fed directly targeted interest rates. My ROC system has been largely unaffected by the news and continued to deliver profitable buy and sell signals for iShares Barclays 20+ Year Treasury Bond (NYSE: TLT).

Relative strength (RS) is shown at the bottom of the chart below. To find an RS rank, I used the 26-week ROC indicator. When ROC is rising and at high levels, RS will also be high. Buys are taken when RS is greater than 80 and sells are signaled when RS falls below 80.

TLT 26-Week ROC Strategy Chart

The chart shows that TLT has suffered its own bear market during the past five years, falling 29% over seven months. Before that big drop, TLT had been benefitting from a flight to quality trade as investors bought U.S. Treasuries while stock prices collapsed. ROC could not completely avoid the panicked buying and selling, and the system did make a trade during that time that rode prices up and down before being closed with a small gain.

Since TLT began trading in 2002, the ROC system beat a buy-and-hold strategy and reduced risk by two-thirds. I define risk as the amount of money lost on a buy signal.

My 26-week ROC strategy is not a perfect trading system, but it has held up under a variety of Fed policies. It is based on the idea that prices move in trends, an idea that seems confirmed by any long-term chart. Trends eventually reverse and the ROC system will provide a sell signal when that happens.

For now, the system continues to show that the risk is too high to buy bonds. This might be because of Fed activity in the markets, but with a system, we don’t need to decipher what the Fed is doing. We simply need to track prices and respond to trading signals.

We don’t have any new signals in the 26-week ROC portfolio this week. The three current positions are:

Michael J Carr 26-Week ROC Strategy Portfolio