"Don't fight the Fed."
This stock market adage has been around for decades, warning investors not to underestimate the impact that Federal Reserve monetary policy has on the direction of the stock market. But if you are one of the many investors worried that looming U.S. interest-rate hikes portend bad things for stocks, you should be aware that the indicator used by the man who coined the "Don't fight the Fed" phrase isn't yet giving a "sell" signal – and likely won't for some time.
I'm talking about the great Martin Zweig, who, sadly, passed away in 2013. Mr. Zweig had an incredibly successful career as a newsletter writer and hedge-fund manager, both in terms of his performance and the impact his groundbreaking research had on the investment world.
In his 1986 book, Martin Zweig's Winning on Wall Street, the author dedicated an entire chapter to his "Don't fight the Fed" advice. "In the stock market, as with horse racing, money makes the mare go," he wrote. "Monetary conditions exert enormous influence on stock prices. Indeed, the monetary climate – primarily the trend in interest rates and Federal Reserve policy – is the dominant factor in determining the stock market's major direction."
In broad terms, when rates were decreasing, Mr. Zweig found that stocks tended to excel. When the Fed was raising rates and the cheap money was drying up, stocks tended to struggle. This may seem like common knowledge today, but Mr. Zweig was among the first to highlight this phenomenon. He developed a system for tracking how bullish or bearish monetary conditions were based on three factors: the prime rate (the rate banks charge their best customers); the Fed's discount rate (the rate at which financial firms can borrow from the Fed) and reserve requirements; and consumer instalment debt levels. The website InvestStrat.com keeps a running tab on these indicators, and currently it shows that we are nowhere near a "sell" signal using the Zweig system. Even if the Fed had raised rates Thursday, we would still be in "buy" territory.
What sort of interest rate hikes would it take to trigger a "sell" signal? The Fed would have to raise the discount rate three times, with less than three months between each of the increases. At the same time, there would need to be two reductions in the U.S. prime rate – at 3.25 per cent, it is currently well below the level (8 per cent) at which Mr. Zweig would consider a single, minor rate hike a bearish sign.
With inflation quite low and the spectre of the 2008-09 financial crisis still looming large in the rear-view mirror, the Fed has been incredibly reluctant to raise rates in recent years, even as the U.S. economy has shown marked improvement. Given that, it seems extremely unlikely it will enter into the type of rapid-fire rate-hike mode that would trigger a "sell" signal on Mr. Zweig's monetary model any time soon.
While macroeconomic factors such as monetary conditions were part of his decision-making process, Mr. Zweig also used a very thorough, detailed approach to assess individual stocks. He looked for companies with fast-growing earnings and sales, lower-than-average debt levels for their industry and accelerating growth, among other things.
His approach became the inspiration for one of my Guru Strategies, which are based on the approaches of different investing greats. Since its mid-2003 inception, a 10-stock U.S. portfolio picked using my Zweig-based approach has returned about 209 per cent (9.7 per cent annualized) compared with about 95 per cent (5.6 per cent annualized) for the S&P 500.
Given that Mr. Zweig's monetary model is likely to be flashing a "buy" signal for the foreseeable future, let's look at a few stocks that my Zweig-based stock-picking model is high on right now.
- MYR Group (MYRG-Nasdaq): This small-cap specialty contractor serves the electrical infrastructure market throughout the United States and Canada. The Zweig strategy likes that it has grown earnings per share at a 27-per-cent pace and sales at a 24-per-cent pace over the long term, and both earnings per share and sales growth accelerated last quarter. It also likes MYR’s zero-per-cent debt-to-equity ratio.
- BofI Holding (BOFI-Nasdaq): BofI – short for “Bank of Internet” – has just one location (in San Diego) but its Internet business allows it to have close to $6-billion (U.S.) in assets and customers across the United States. The Zweig approach likes its 27-per-cent long-term EPS growth rate and 26-per-cent long-term sales growth rate. It also likes that EPS growth accelerated in the most recent quarter to 42 per cent.
- Tumi Holdings Inc. (TUMI-NYSE): Tumi offers travel and business products, which it distributes in more than 75 countries. The Zweig strategy likes its 29-per-cent long-term EPS growth, which accelerated last quarter to 39 per cent, and its zero-per-cent debt-to-equity ratio.
Disclosure: I'm long MYRG and BOFI.
John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.