CFA Institute Journal Review (formerly CFA Digest) summarizes "Stock Returns over the FOMC Cycle," by Anna Cieslak, Adair Morse, Annette Vissing-Jorgensen, published in Journal of Finance, Vol. 74, No. 5 (October 2019).
Using data from 1994 to 2016, the authors find that the equity premium is earned during even weeks after Federal Open Market Committee meetings. They reveal positive average excess returns during even weeks and negative average excess returns during odd weeks, with the difference between these returns being statistically significant. They also show how a trading strategy based on investing during even weeks beats one that invests on all days.
What Is the Investment Issue?
The authors investigate whether the Federal Reserve Board has an impact on the stock market and, if so, how much of the stock returns can be attributed to the Fed. Rather than focusing on short time periods around the Federal Open Market Committee (FOMC) announcements, the authors study the full cycle of days between scheduled FOMC meetings. This allows them to assess the Fed’s effect over the entire FOMC cycle.
How Did the Authors Conduct This Research?
The authors use data from 1994 to 2016. During this period, 184 FOMC meetings were scheduled. Using excess returns (i.e., stock market return minus T-bill return) data from the Fama–French factor file on Kenneth R. French’s website, the authors perform analyses on weeks relative to the FOMC announcements. In particular, in FOMC cycle time, week 0 is days –1 to 3, week 2 is days 9 to 13, week 4 is days 19 to 23, and week 6 is days 29 to 33. The authors calculate average excess returns during each of these “even weeks,” as well as during “odd weeks.”
What Are the Findings and Implications for Investors and Investment Professionals?
The authors found that average excess returns during even weeks range from 0.33% to 0.60%. By contrast, during odd weeks, the average excess returns range from –0.09% to –0.18%. The authors consider this 12 bps average excess return differential between even weeks and odd weeks statistically significant at the 1% level based on t-statistics that were robust to heteroskedasticity. Additionally, the authors conclude that the excess return pattern does not result from events, such as reserve maintenance periods, macroeconomic news releases, or earnings announcements. Consequently, the authors conclude that over the past 23 years, the entire equity premium has been earned in FOMC cycle even weeks. They argue that the Fed accomplishes this by reducing the price or amount of uncertainty, which subsequently lowers the equity premium. They posit that to lessen uncertainty, the Fed reduces downside risk by promising to act, or provide stimulus, as needed. The Fed informally communicates these promises through the media or the financial sector.
In addition, the authors show the economic significance of their findings by comparing the performance of three trading strategies. Strategy A holds the stock market over the entire 23-year period, resulting in a Sharpe ratio of 0.45. Strategy B invests in the stock market only during even weeks, resulting in a Sharpe ratio of 0.92—double that of Strategy A. Strategy C invests in the stock market only during odd weeks, resulting in negative returns. To quantify the difference in performance in monetary terms, the authors explain that $1 invested in Strategy A in 1994 would generate $7.68 by the end of 2016, whereas $1 invested in Strategy B would generate $15.22 over the same time period. Strategy C, on the other hand, transforms the $1 invested into $0.51.