It's Friday. The end of the week. This seems like an appropriate day to put a wrap on this impromptu series of articles about timing the market based on the direction of interest rates. The two previous articles are linked below.

In this article series we've been looking at past performance of the Dow Jones 30 Industrials as they relate to the Federal Reserve Target Funds Rate. The theory, proposed a very long time ago by a friend, suggested that investors should buy when the Fed begins reducing rates and sell when the Fed begins raising them. The theory behind this rudimentary market timing system holds that easy money allows for market expansion and growth, which in turn means higher stock prices. Conversely, rising interest rates put the brakes to growth and hold stock price appreciation back.

Today's chart shows a period of 100 months starting out where yesterday's chart left off. The green boxes indicate periods of time where our hypothetical investor would be in the market because interest rates are dropping. The red boxes are periods when the Fed raised rates and when we're out of the market.

If you ever get into a conversation with someone about market timing based on the Fed Funds Rate, this is the chart you'll want to have handy. Clearly the "buy" timing indicators worked in this 100 month period. Unfortunately the "sell" timing indicators turned out to be "buy" indicators. You have to wonder what's the use of a market timing system that's 180° wrong half the time.

Our table of buys and sells based on the Fed Funds Rate indicator (above) compared to a simpler buy and hold strategy clearly shows how costly this market timing strategy can be. Our buy and hold control case outpaced the more active trading strategy to the tune of $85,000 over this 100 month period. Indeed, buy and hold returned compounded gains of nearly 15½% per year over this time period. Our market timer only managed a little over 12% per year.

Not only that, but our buy and hold investor didn't pay any taxes along the way. Our more active trader had to cough up capital gains taxes on a $39,000 gain in '93 and on $95,000 of gains in 1998, further reducing his return on investment.

The more I look into this, the more I have to label this timing strategy as busted. I have not seen anything compelling enough about the Fed Funds Rate market timing strategy that would lead me to believe it's better than a simple buy and hold strategy. In fact, it's a recipe for underperforming the market by a significant margin.

Previous articles in this series:
Are Falling Interest Rates a Buy Signal?

A Second Look at Market Timing Using Interest Rates