Reviewing The Long Term Relationship Between the Effective Federal Funds Rate and Stock Market Sector Returns Jeff McDermott University of Central Florida June 2006

Overview Prior research on this subject Prior research on this subject Insignificant correlation on anticipated announcements Insignificant correlation on anticipated announcements Negative correlation with unexpected increase announcement (and vice versa) Negative correlation with unexpected increase announcement (and vice versa) Volatility will fluctuate around planned news events (FOMC meetings) Volatility will fluctuate around planned news events (FOMC meetings) Will any specific industries show a correlation with the fed funds rate? Will any specific industries show a correlation with the fed funds rate?

Why is this important? To allocate an investment portfolio over appropriate industries based on economic conditions To allocate an investment portfolio over appropriate industries based on economic conditions Thus maximizing returns Thus maximizing returns Explore the possibility of using the yield curve/fed funds futures to choose investment areas Explore the possibility of using the yield curve/fed funds futures to choose investment areas Continue to expand our knowledge of the relationship between the federal funds rate and the financial markets Continue to expand our knowledge of the relationship between the federal funds rate and the financial markets

Prior Research Largely devoted to study of anticipated vs. unanticipated events Largely devoted to study of anticipated vs. unanticipated events Anticipated changes virtually no effect Anticipated changes virtually no effect Unanticipated changes negatively correlated approximately one percent return for every 25 basis points Unanticipated changes negatively correlated approximately one percent return for every 25 basis points Likely causes: pressure on corporate balance sheets, lower access to credit and reduction in investor willingness to assume riskier assets during times of increasing rates Likely causes: pressure on corporate balance sheets, lower access to credit and reduction in investor willingness to assume riskier assets during times of increasing rates

Prior Research Any effects found tend to be more dramatic in Any effects found tend to be more dramatic in Smaller cap stocks Smaller cap stocks Higher beta stocks Higher beta stocks Volatility tends to soften before the announcement and may spike afterwards, particularly on negative market news Volatility tends to soften before the announcement and may spike afterwards, particularly on negative market news Noted research by Bernanke and Kuttner (2004); Bomfim (2000); and Thorbecke (1997) Noted research by Bernanke and Kuttner (2004); Bomfim (2000); and Thorbecke (1997)

Research Plan Regress various stock market sector indices with the effective fed funds rate Regress various stock market sector indices with the effective fed funds rate Monthly data over a period of 20 – 30 years depending availability of data on indices Monthly data over a period of 20 – 30 years depending availability of data on indices Not attempting to isolate any events or surprises at this time Not attempting to isolate any events or surprises at this time Simply compare data over a long time frame to determine if any trends appear over time Simply compare data over a long time frame to determine if any trends appear over time

Research Plan Two regressions done Two regressions done Monthly change for FF rate regressed on monthly index change Monthly change for FF rate regressed on monthly index change Interest rate environment indicator Interest rate environment indicator Δ in FF rate > = 1 Δ in FF rate > = > Δ in FF rate > = > Δ in FF rate > = > Δ in FF rate = > Δ in FF rate = -1

Identification of Indices $BKX PSE Banking Index $XBD AMEX Broker/Dealer Index $XCI AMEX Computer Tech Index $CYC Morgan Stanly Cyclical Stock Index $DRG AMEX Pharmaceutical Index $RCI* Dow Jones REIT Composite Index $PSE PSE Technology Index $UTY PSE Utilities Index

Data Analysis Table 1 Δ in effective FF rate vs. Δ in $SPX InterceptCoefficientStd. ErrorP ValueR-Square Fed General Direction

Data Analysis Table 2 Industry Comparison vs. Effective Fed Funds Rate Index (Time) InterceptCoefficientStd ErrorP-ValueR-Square $BKX ( ) $XBD ( ) $XCI ( ) $CYC ( ) $DRG ( ) $RCI ( $PSE ( ) $UTY ( )

Conclusion No sufficient evidence to indicate that industry indices have a relationship to federal funds direction No sufficient evidence to indicate that industry indices have a relationship to federal funds direction Consistent with prior research Consistent with prior research

Conclusion Why a weak correlation? Why a weak correlation? Stock market tendency to trend upwards Stock market tendency to trend upwards Industry specific news more important Industry specific news more important

Application Investors still must be prepared for surprises Investors still must be prepared for surprises The best we can do is hedge our portfolios The best we can do is hedge our portfolios Negatively correlated stocks Negatively correlated stocks Investment mix of stocks, bonds and money markets Investment mix of stocks, bonds and money markets More exotic strategies such as protective puts and covered calls More exotic strategies such as protective puts and covered calls

Disclaimer Nothing presented in this presentation should be considered investment advice. Each investor’s individual situation and risk tolerance should be considered before making any investment decisions. The presenter strongly encourages you to consult a financial advisor before making any investment decisions.