Jeffrey M. Mercer

Can Precious Metals Make Your Portfolio Shine

We extend earlier studies and present new evidence on the benefits of adding precious metals to U.S. equity portfolios. We report five major findings related to the potential benefits of investing in precious metals either directly via the commodity or indirectly via equities. First, we find that adding a 25% allocation to the equities of precious metals firms improves portfolio performance substantially. Second, our evidence indicates that an indirect investment dominates a direct investment in precious metals. Third, relative to platinum and silver, gold has better stand-alone performance and appears to provide a better hedge against the negative effects of inflationary pressures. Fourth, the benefits of precious metals are strongly tied to monetary conditions. Finally, while the benefits of adding precious metals to an investment portfolio varied somewhat over time, they prevailed throughout much of the 34-year period. Overall, our evidence suggests that investors could improve portfolio performance considerably by adding a significant exposure to the equities of precious metals firms.

Is Fed Policy Still Relevant for Investors

Thirty-eight years of U.S. data indicate that U.S. monetary policy continues to have a strong relationship with security returns. U.S. stock returns are consistently higher and less volatile when the Federal Reserve is following an expansive monetary policy. Furthermore, the monetary policy–related return patterns of companies considered to be most sensitive to changes in monetary conditions are much more pronounced than average patterns. Finally, the influence of U.S. monetary policy is global; international indexes have return patterns similar to those for the U.S. market. Overall, the evidence suggests that investment professionals should continue to consider monetary conditions when performing fundamental analysis of U.S. and international securities. Numerous studies have documented the relationship between monetary policy and security returns, but the relevance of monetary conditions in investment analysis is still debated. In particular, questions have been raised about the continued importance of U.S. monetary policy in recent periods. To study this issue, we analyzed stock returns following changes in the U.S. Federal Reserve’s monetary policy in 21 separate monetary policy environments that occurred from the middle of July 1963 to early 2001. We considered U.S. stocks in general, U.S. stocks grouped according to size and along the value–growth dimension, U.S. stocks by industrial sector, and international stocks. We identified a change in Fed monetary policy as a directional change in the Fed discount rate. We used daily returns (rather than monthly returns) to provide an accurate assessment of returns. To the cross-sectional study, we added an exploration of the time-series consistency of all the relationships. Our findings support the following claims: First, monetary conditions have had and continue to have a strong relationship with security returns. In particular, periods of expansive monetary policy are associated with strong stock performance (higher-than-average returns and lower-than-average risk), whereas periods of restrictive monetary policy generally coincide with weak stock performance (lower-than-average returns and higher-than-average risk). Second, a highly consistent relationship between monetary conditions and stock returns is evident over time. Although initial analysis suggests the relationship has diminished, a more thorough investigation indicates that a single monetary period that occurred in the mid-1990s is largely responsible for this conclusion. Third, small-cap companies are more sensitive than large-cap companies to changes in monetary conditions. Portfolios of small-cap stocks have economically and statistically significant monetary policy–related return patterns that are consistent over time. Fourth, cyclical stocks have a much higher sensitivity to changes in monetary conditions than defensive stocks. For example, stocks in the cyclical consumer goods, cyclical financial services, and information technology sectors had expansive-period returns that were more than 26 percentage points a year higher than the returns they earned during restrictive periods. Finally, U.S. monetary policy has an important influence on global markets. We found significant return patterns related to U.S. monetary policy for five international stock indexes. This evidence is consistent with the prominent role U.S. economic conditions play in the prospects of foreign companies. Overall, our evidence strongly suggests that practitioners should devote considerable attention to monetary conditions as part of a thorough economic analysis. Furthermore, because sensitivity to changes in monetary conditions deviates considerably among sectors, a rigorous industry analysis is also essential. Finally, investment professionals who are attempting a sector or industry rotation strategy should carefully monitor changes in Fed monetary policy.

Sector Rotation and Monetary Conditions

We investigate the efficacy of a sector rotation strategy that utilizes an easily observable signal based on monetary conditions. Using 33 years of data, we find that the rotation strategy earns consistent and economically significant excess returns while requiring only infrequent rebalancing. The strategy places greater emphasis on cyclical stocks during periods of Fed easing, and overweights defensive stocks during periods of Fed tightening. Interestingly, the benefits from the rotation strategy accrue predominantly during periods of poor equity market performance, which is when performance enhancement is most valued by investors. Specifically, during restrictive monetary periods, returns to the strategy are nearly twice that of comparable investments, yet the strategy assumes less risk. Overall, our results suggest that investors should consider monetary conditions when determining their portfolio allocations

Gains from Active Bond Portfolio Management Strategies

The belief that excess returns can be achieved by correctly timing changes in yields and/or yield spreads motivates active bond portfolio management strategies. Given the rich literature linking yield spread patterns to both the business cycle and changes in short-term interest rates, the authors motivate and demonstrate the efficacy of simple spread-trading strategies tied to both. Using 34 years of fixed income returns, they demonstrate that straightforward rules would have led to superior risk-adjusted performance relative to standard fixed-income benchmarks. Furthermore, the strategies tied to short-maturity interest rates are based on the use of past information only.

Time Variation in the Benefits of Managed Futures

This article provides new evidence on the return/risk benefits of adding managed futures to the investment set. We investigate four mean-variance efficient allocations, ranging from conservative to aggressive. The results indicate that with as little as 10% of the original portfolios reallocated to futures, portfolio return (risk) is significantly increased (decreased) for all four allocations. Importantly, the analysis shows that a simple indicator of the Feds monetary policy stance can be used to reliably forecast when futures provide the most benefit. Specifically, significant improvements in Sharpe ratios occur when the Fed takes a restrictive monetary policy stance (about half the time over our 40-year sample). In contrast, there is no significant improvement when the Fed takes an expansive policy stance. Finally, the authors show that these results are consistent through time.

Price Discovery in the Treasury‐Bill When‐Issued Market

When‐issued (i.e., forward) trading in T‐bills yet to be auctioned provides a unique environment for examining price discovery. Because T‐bills are auctioned in a sealed‐bid process, when‐issued traders cannot observe the spot market price. Yet the forward price must ultimately converge on the auction outcome price. Our results indicate that traders in the when‐issued market “discover” the ultimate auction price. Little evidence is found that standard order flow variables contribute to price discovery. Instead, the ability to observe a few trades with relatively small volume in the when‐issued market is sufficient to discover the auction price resulting from the sealed‐bid process.

Do Traders Benefit from Riding the T-Bill Yield Curve?

Studies show that riding the Treasury bill yield curve consistently provides higher returns than a matched-horizon buy-and-hold strategy and this article confirms earlier findings. Using Federal Reserve (FRED) interest rate data on 91- and 182-day T-bills and GovPX interdealer tick data over the period January 2001–September 2007, the authors find that no interdealer sales of 182-day T-bills occurred at the time needed to complete a ride, suggesting that no trader benefited through the interdealer market. They also show that selling the seasoned bills at the end of the ride in the new 91-day on-the-run secondary market or its when-issued market would have provided higher returns than the returns computed using the FRED data. But to generate

Taxable and tax-exempt interest rates: The link with inflation

1 million of annual riding returns would require capturing 85% of the available market volume every week. The authors conclude that riding the T-bill yield curve continues to appear viable across time because of transaction volume limitations.

REIT Momentum and Characteristic-Related REIT Returns

Abstract A single-equation model utilizing taxable/tax-exempt yield spreads is developed to test restrictions required by the Darby–Feldstein inflation/tax hypothesis. Evidence indicates these restrictions generally can be rejected for post-Accord data and that there is important information in both yields linking them to inflation.