A long time ago, when the thought of being a Millionaire was only a far away dream, I had a friend who told me his theory for when to invest in what kinds of securities. His buy and sell triggers had only to do with what was happening with interest rates. His theory was simple: You should be buying stocks when the Fed Funds Rate is dropping. When rates top out and start to drop it's time to sell and move to cash or to bonds.

His theory was based on the premise that a lowered Fed Funds Rate meant more liquidity, which would lead to higher stock prices as businesses were able to obtain money for expansion more cheaply. Conversely, when money's getting tighter, businesses find it harder to borrow. Debt is more expensive, making expansion harder to finance. Without expansion, businesses and their stock prices don't grow.

I never followed his advice. The concept seemed to make sense; but my gut told me it couldn't be that simple. So today, after all these years, I've done the work to either prove or dispel the myth. The chart below shows the adjusted closing price of the Dow Jones Industrials and the Federal Reserve Funds Rate from 1992 to present.

Kind of small? Here's a bigger version

If my buddy's theory were true, an investor would have been in and out of the market several times over the past decade and a half based on the changing directions of the red Fed Funds Rate line in the chart. In late 1990's he would have been selling into the dot com irrational exuberance. Later on, as both the market dropped and interest rates began to bottom out, he'd have been a buyer. Today he'd be looking at the new Dow Jones Industrials recent record highs and last week's interest rate cut and start to think about lightening up on stocks.

It's a little harder to see this sort of relationship going back much further than that though. From the early 80's through the dot-com boom the best strategy despite interest rate moves was buy and hold.

Conclusion? Hard to say. Usually when you look into these macro trends it seems like what worked well in the past was no longer the case. Here, the theory which I didn't think held water in the past, and which in fact did not, seems to have worked well more recently. I think this one warrants more study.