Yesterday we took a brief look at whether a change in the direction of interest rates was an indicator of whether you should buy or sell stocks. The theory says that when interest rates - in this case we're watching the Fed Funds Target rate - are falling, money becomes cheaper. Less expensive debt allows corporations to borrow more aggressively and in turn expand more rapidly. Conversely, when interest rates are on the rise stocks will fall because credit is tight and expansion is more difficult.

In yesterday's article it appeared this strategy, in recent years at least, was a winner. In earlier years the data didn't seem to support the strategy. I had an idea that because of the scale of the chart some of the ups and downs in the market were less visible. I thought today it would be a good idea to drill down into an earlier period on yesterday's chart to see if this interest rate trade triggers strategy works.

This chart uses a subset of the data I showed in yesterday's chart. I selected an arbitrary time period of approximately 100 months starting in September, 1982. The red and green bars represent approximate times in which the interest rate trade trigger strategy indicates you should be in or out of the market. Green means you should be invested. Red means you should be in cash.

Simply eyeballing the chart shows that indeed the strategy works. In every case the blue line, representing the Dow Jones Industrial Average adjusted closing price, is lower as it enters the green bar on the left and higher as it exits it on the right. The Fed Funds Target Rate indicated profitable trades in every case during this 100 month sample period. The table below shows an example series of trades based on the strategy using a hypothetical $100,000 initial investment.

The Fed Funds Rate stock timing strategy resulted in a doubling of the portfolio value in a little over seven years. That's approximately 10% per year.

Our hypothetical investor realized a few interesting benefits of this investment strategy, too.

1. Even though he would have made money during the "out of the market" period in 1983-1984, the return would have been small compared to his big ups and downs during that time period.
2. His money sat on the sidelines during a particularly gut-wrenching period in the summer of 1987.
3. He would only have been invested in the market about 50% of the time. The rest of the time his cash deposits would have benefited handsomely from rising interest rates.

It appears the Fed Funds Rate market timing strategy works. In our first in-depth look, the strategy yielded positive returns 100% of the time; and it tended to avoid the most volatile periods in which to be in the market. Unfortunately, however, there is one test it fails. The strategy did not compare well with an even simpler buy-and-hold strategy.

If our hypothetical investor went "all in" at the beginning of our test period, his $100,000 initial investment would have nearly tripled in value. In this case the buy-and-hold strategy added about 5% per year to our overall investment return. The downside? Volatility. Hanging on during a big market drop like the one on that infamous day in October of 1987 takes guts. Our hypothetical investment lost 30-35% of it's value that Autumn. It equates to a drop in our hypothetical portfolio value from about $300,000 to only $200,000 - a hard drop to stomach.

If you have the stomach for that much risk, the buy and hold strategy is clearly a winner. But if you think you'd lose sleep over this kind of volatility, then the Fed Funds Rate market timing strategy would, in this case at least, be a conservative approach which still yields decent returns.

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Are Falling Interest Rates a Buy Signal?