Profiting From The 'Pre-FOMC Drift'

Jul.25.12 | About: SPDR S&P (SPY)

A very interesting article appeared on the popular financial counter-cultural website Zerohedge recently. In it, the authors noted a statistically significant rise in equities before the FOMC interest rate decision announcement that's been occurring since 1994, precisely when the Fed began announcing their après meeting rate decisions. They dubbed this phenomenon pre-FOMC drift. Their analysis led to two observations:

"1. Since 1994, there has been a large and statistically significant excess return on equities on days of scheduled FOMC announcements.

2. This return is earned ahead of the announcement, so it is not related to the immediate realization of monetary policy actions."

The article gives statistical proof that the pre-FOMC drift is a real phenomenon. Being the eternal skeptic, I wanted to see if this was, indeed, the case.

The findings of the original article
In the original article, a regression analysis was performed on the S&P 500 index to determine the pre-FOMC drift while accounting for dividends and excess return over the risk free rate. It was found that the FOMC's rate decision day's close (Day 0) minus the close of the previous day (Day -1) was 33 basis points above the typically observed 1 basis point advance. That's huge!

Not only that, but if one looks at data collected at 2pm ET on the day before to 2pm ET on the date of the rate decision (Fed rate decisions were scheduled for 2:15pm ET until very recently), a 49 basis point gain was realized. That's even more impressive.

My test set-up
The original article showed statistically significant data going back to 1994. In the interest of (MY) time, I decided to limit the analysis to the past 5 years of regularly scheduled FOMC meetings (of which there are eight per year) beginning in 2007 and extending through the present for a total of 44 dates.1

I'll be taking the simple approach meaning that I'll not be doing a regression analysis nor will I consider dividends or transaction fees. Basically, what I want to show is how a trader could (or could not) have profited from directly buying an S&P 500 vehicle (the SPY or SPX futures) in the one to three day time frame surrounding the FOMC meetings.

I gathered data from the SPX (the S&P 500 index) on the following dates:
1. The opening price from the day before the FOMC announcement (Day -1)
2. The opening price from the day of the FOMC announcement (Day 0)
3. The closing price from the day of the FOMC announcement (Day 0)
4. The closing price from the following day of the FOMC announcement (Day +1)

Note that data was not collected for the 2pm-2pm (Day -1 to Day 0) scenario because of time limitations (that would have been an extra 88 data points). Also, I was curious to see which of the possible time frames using the above data points would be the most profitable. The table below shows the average total gain for each of the following scenarios:

1. Day 0 open less Day -1 open
2. Day 0 close less Day -1 open
3. Day 0 close less Day 0 open
4. Day +1 close less Day -1 open
5. Day +1 close less Day 0 open
6. Day +1 close less Day 0 close

Click to enlarge

The results
The table above shows that scenarios #2 and #3 are the most profitable. Since the statistics are nearly identical, I'll be looking at only scenario #3 (buying on the opening day of the Fed rate decision and selling on the close) because as a trader, if I can make the same profit over one day rather than two, I'll definitely take the one day approach. Further, you can see that had you bought the S&P 500 using this approach from 2007, you would have benefited to the tune of 394 points with an average gain of 9 points per announcement, although you'd have to assume a standard deviation (a measure of risk) of 18 points.2

The below yearly chart seems to indicate that the effect is heightened during periods of increased market volatility. You can see that returns are amplified during times of stress (late 2007 through mid 2009), although a more rigorous analysis should be performed to prove this observation. It may be that in times of crisis, investors are counting on the Fed to take decisive action.

Click to enlarge

Summary
The analysis here shows that the pre-FOMC drift trading strategy would have been a very profitable one. If implemented as described above, a hypothetical investment beginning in 2007 would have realized a potential gain of 394 points on the SPX. In contrast, had the SPX been bought at the beginning of January of 2007 (at 1418) and held until now, the investor would be down 68 points (as of today's close at 1350).

The original article showed that more than 80% of the annual equity premium in the S&P 500 has been earned over the 24 hours preceding scheduled FOMC rate announcements. The significance of this conclusion is mind-boggling. For starters, the fact that this effect seems to be amplified during periods of heightened market uncertainty implies that it is based at least partially on hope (too bad Pandora didn't let that emotion escape, too!) and shows just how much influence the Fed wields. (There are similar effects regarding central bank rate meetings in other countries as well.) The original article also showed that without this pre-FOMC drift boost, the S&P 500 would only be trading around 600, less than half of where it is now. The implications of this effect are profound.

Conclusion
The aforementioned pre-FOMC drift scenario has been shown to be a viable and profitable trading strategy. One burning question remains: Will the fact that everyone now knows about it render it useless?

Footnotes
1During the sub-prime mortgage crisis, the Fed held many unscheduled meetings which are not considered since I wasn't sure if I'd be comparing apples to apples.
2This means that 67% of the time you'd have a return ranging between 9 +/- 18, or between a loss of 9 points and a gain of 27 points.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.