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A recent S&P downgrade on U.S. debt AAA rating might make investors cautious on treasury safe haven status. However, following the Fed is still a very profitable investment strategy. We follow Doug Roberts' "Follow the Fed" strategy. The strategy was proposed by Roberts in his book Follow the Fed to Investment Success: The Effortless Strategy for Beating Wall Street. Here is the synopsis of the strategy:

This strategy follows the Fed's stance and allocates its assets in three equal parts-large/small stocks, gold/Treasury bonds and intermediate government notes. It aims to achieve a higher return while lowering risks.

This strategy is simply based on the fed monetary policy to follow the Fed. Research shows that big caps behave better than small caps when money is tight, while small caps outperform big caps when money is easy. A similar relationship is also found in gold and Treasury bonds. Gold is doing better than Treasury bonds when the Fed’s easy, and vice versa. Switching between large and small stocks, gold and Treasury bonds depends on the Fed’s monetary policy.

To lower the risk still further, simple intermediate government notes are added to the portfolio. This strategy allocates assets equally among large/small stocks, gold/Treasury bonds and intermediate government notes.

Determine whether money is tight or easy

The indicator we use is T-bill –12m value minus Inflation–12m value, as described in the articles. If the former is larger than the latter, then the Fed's money policy is tight. The T-bill–12m is the trailing 12-month compound return using the last 12 monthly “T-bill” values. Similarly, the Inflation–12m measures the trailing 12-month compound return using the last 12-month inflation values. Inflation is calculated as the change in CPI index between this month and last month divided by last month’s CPI index. Here CPI index is referred to CPIAUCSL-Consumer Price Index For All Urban Consumers: All Items.

We can also compare the above indicator value with the 64-day simple moving average value of the indicator. If the former is larger than the latter, then the Fed's tight, and vice versa. We also create another indicator — short term interest rate minus CPI — to determine the money status. If the indicator value is above 0, then the Fed’s tight. The 64-day simple moving average of the indicator value can also served as an alternative threshold value.

Portfolios

If money is tight, the portfolio is composed of 33.33% in large stocks (SPY or VTI); 33.33% in Treasury bonds (IEF or TLT); 33.33% in intermediate government notes ((NYSEARCA:IEF)). If money is easy, the portfolio is made up of 33.33% in small stocks (IWM or IJR); 33.33% in gold (GLD or IAU); 33.33% in intermediate government notes (IEF).

Switching frequency

The strategy adjusts portfolios every month according to the money status. Refer here for more detailed strategy description. Model portfolios based on this strategy has done really well in the past 10 years. The following shows how a model portfolio is compared against S&P 500 and a balance index fund (Vanguard Balance Fund index VBINX):

Portfolio Performance Comparison (as of Aug. 11)

Portfolio/Fund Name YTD 1Yr AR 1Yr Sharpe 3Yr AR 3Yr Sharpe 5Yr AR 5Yr Sharpe
P Doug Roberts Follow the Fed Add Treasury Note One Month Simple Indicator Moving Average 64 Days 7.66% 21% 246% 12% 97% 11% 87%
SPY -5.87% 5% 58% -3% 2% -1% -2%
VBINX -1.38% 5% 203% 2% 32% 3% 28%

Five-Year Chart

[Click to enlarge]
Detailed comparison is here. Currently, the strategy favors: Gold (GLD, IAU), Small stocks (IWM or IJR ) and Treasury (IEF). From Jan. 1, 1997 to Aug. 11, 2011, this strategy averaged 10.9% annually, a remarkable feat.

Source: Following the Fed With Gold and Treasuries Still Works