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Executive summary:

  • Martin Zweig's Winning on Wall Street introduced his Fed Indicator, which the author of the classic employed in his habitual monitoring of the monetary policies of the U.S. Federal Reserve.
  • The successful market timer routinely engaged in FedWatching because loose monetary conditions are associated with rising share prices and tight monetary conditions are associated with falling share prices.
  • Due to the global financial crisis that became apparent in 2007, the Fed adopted monetary-policy levers that did not exist when Winning on Wall Street was originally published in 1986.
  • Therefore, one has been compelled to construct a Martin Zweig-like Fed Indicator that integrates the innovations of the 21st century at the central bank.

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Martin Zweig's Winning on Wall Street is among the best books on the U.S. equity market ever published - as great, insightful and provocative in its way as Benjamin Graham's The Intelligent Investor and Edwin Lefèvre's Reminiscences of a Stock Operator are in theirs.

One of the many helpful pointers Zweig presented in his magnum opus is the Fed Indicator, which the author employed in his habitual monitoring of the monetary policies of the Federal Reserve. It was among the sharpest arrows in the quiver used by the highly successful market timer.

Like many other financial-market participants, Zweig kept one or both eyes on Fed operations as a matter of course because loose monetary conditions are associated with rising share prices and tight monetary conditions are associated with falling share prices, all other things being equal (or even unequal).

Basically, the Federal Reserve had three main monetary-policy levers to either push down or pull up when Winning on Wall Street was originally published in 1986: the Discount Rate, the Federal Funds Rate and Reserve Requirements. Zweig accounted for all three in building his Fed Indicator.

Since then, the global financial crisis that became apparent in 2007 led the Federal Reserve under former Chairman Ben S. Bernanke to adopt additional monetary-policy levers at the central bank, collectively constituting a kind of life support for the moribund economy and financial markets.

Some of these new levers had been employed previously in one form or another in the U.S., such as Operation Twist I in 1961, which I explicitly discussed in "Go, Chubby, Go: Let's Twist Again!" at J.J.'s Risky Business and "The First Operation Twist And S&P 500 Behavior" at Seeking Alpha. And some of them had been used previously in one form or another elsewhere, such as quantitative easing (QE) in Japan in the early years of the 21st century, which Bernanke implicitly discussed in his "Deflation: Making Sure 'It' Doesn't Happen Here" address at the National Economists Club in Washington (aka the "Helicopter Ben" speech).

Zweig died about a year ago, so I do not know if he believed his estimable Fed Indicator needed any tweaks to bring it up-to-date by integrating either some or all of the Federal Reserve's comparatively recent innovations, especially given the possibility they may prove to be more temporary than permanent features of the monetary-policy landscape.

Whether Zweig did or did not, I definitely require a Fed Indicator for the 21st century. And this article reflects the state of my thinking on it.

The most important difference between Martin Zweig's Fed Indicator and my Martin Zweig-like Fed Indicator is that he had a big honkin' pile of contextual historical data when he constructed his a long time ago and I have no such pile of contextual historical information as I fashion mine here and now.

Martin Zweig's Fed Indicator accounts for three monetary-policy levers distilled into two components, and my Martin Zweig-like Fed Indicator accounts for five-plus monetary-policy levers distilled into four components. In accordance with Zweig's guidelines as much as possible, I grade this quartet as follows:

Discount Rate/Federal Funds Rate

Because an initial decrease in either rate would be bullish for equities, it would lead not only to the subtraction of any accumulated negative points but also to the addition of two positive points, the first expiring after six months, the second expiring after 12 months. Each subsequent decrease would lead to the addition of one positive point, which would expire after six months.

Due to the fact an initial increase in either rate would be bearish for stocks, it would lead not only to the subtraction of any accumulated positive points but also to the addition of one negative point, which would expire after six months. Each subsequent increase would lead to the addition of one negative point, which would expire after six months.

Neither the discount rate nor the federal funds rate has changed in the past 12 months.

Current Level: 0.

Reserve Requirements

Because an initial decrease in reserve requirements would be bullish for equities, it would lead not only to the subtraction of any accumulated negative points but also to the addition of two positive points, the first expiring after six months, the second expiring after 12 months. Each subsequent decrease would lead to the addition of one positive point, which would expire after six months.

Due to the fact an initial increase in reserve requirements would be bearish for stocks, it would lead not only to the subtraction of any accumulated positive points but also to the addition of one negative point, which would expire after six months. Each subsequent increase would lead to the addition of one negative point, which would expire after six months.

Except for indexing, reserve requirements have not changed materially in the past 12 months.

Current Level: 0.

Interest On Required Reserve Balances And Excess Balances

Because I believe an initial decrease in the interest rates the Federal Reserve Banks pay on balances maintained to satisfy reserve requirements and on excess balances would be bullish for equities, it would lead not only to the subtraction of any accumulated negative points but also to the addition of two positive points, the first expiring after six months, the second expiring after 12 months. Each subsequent decrease would lead to the addition of one positive point, which would expire after six months.

Due to the fact I think an initial increase in these interest rates would be bearish for stocks, it would lead not only to the subtraction of any accumulated positive points but also to the addition of one negative point, which would expire after six months. Each subsequent increase would lead to the addition of one negative point, which would expire after six months.

These interest rates have not changed in the past 12 months.

Current Level: 0.

Quantitative Easing (And Other Special Programs)

Because I believe an initial increase in QE would be bullish for equities, it would lead not only to the subtraction of any accumulated negative points but also to the addition of two positive points, the first expiring after six months, the second expiring after 12 months. Each subsequent increase would lead to the addition of one positive point, which would expire after six months.

Due to the fact I think an initial decrease in QE would be bearish for stocks, it would lead not only to the subtraction of any accumulated positive points but also to the addition of one negative point, which would expire after six months. Each subsequent decrease would lead to the addition of one negative point, which would expire after six months.

The Fed announced an initial decrease in QE on December 18 and a subsequent decrease in it on January 29.

Current Level: -2.

The Bottom Lines

It bears repeating that the most significant difference between Martin Zweig's Fed Indicator and my Martin Zweig-like Fed Indicator is that he had a big pile of contextual historical data when he built his a long time ago and I have no such pile of contextual historical information as I construct mine here and now.

With this caveat in mind, I have developed the following scoring system on a tentative basis for my indicator, which may or may not be congruent with things to come:

  • Bullish = +3 points or above.
  • Neutral = From +2 to -2 points.
  • Bearish = -3 points or below.

Once my indicator's score departs the neutral zone, I will be comparing and contrasting the subsequent behaviors of the SPDR S&P 500 ETF (NYSEARCA:SPY), SPDR S&P MidCap 400 ETF (NYSEARCA:MDY) and iShares Core S&P Small-Cap ETF (NYSEARCA:IJR). If my indicator works the way I believe it may, then SPY might perform better than MDY and MDY might perform better than IJR (i.e., I think the move to tighter monetary conditions from looser monetary conditions would be felt first by small-capitalization companies, then by mid-caps and finally by large-caps, all else being equal).

Meanwhile, here is a table with the current levels of my Martin Zweig-like Fed Indicator:

(click to enlarge)

Note: On the "Quantitative Easing (And Other Special Programs)" line, one negative point will expire on June 18 and another negative point will expire on July 29.

Source: This table is based on proprietary analyses of Federal Reserve data.

As Zweig was wont to say, "Don't fight the Fed."

Disclaimer: The opinions expressed herein by the author do not constitute an investment recommendation, and they are unsuitable for employment in the making of investment decisions. The opinions expressed herein address only certain aspects of potential investment in any securities and cannot substitute for comprehensive investment analysis. The opinions expressed herein are based on an incomplete set of information, illustrative in nature, and limited in scope. In addition, the opinions expressed herein reflect the author's best judgment as of the date of publication, and they are subject to change without notice.

Source: Building A Martin Zweig-Like Fed Indicator Integrating Innovations Of The 21st Century