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As the Fed Raises Interest Rates, Let These 2 Mantras Guide Your Investing

As the Fed Raises Interest Rates, Let These 2 Mantras Guide Your Investing

Posted September 1, 2022 at 11:15 am
Steve Sosnick
Barron's

There’s a lot to be said for time-tested market adages. They wouldn’t stick around if they weren’t useful. “Don’t short a dull tape,” “bulls make money, bears make money, pigs get slaughtered,” and “dead cats don’t bounce” all have their relevance, but “don’t fight the Fed” is almost certainly the most useful of all.

The phrase “don’t fight the Fed” is widely credited to Martin Zweig, a long-time fixture in Barron’s. The rationale is deceptively intuitive. If the Federal Reserve is cutting interest rates or is generally accommodative, then the ensuing liquidity should provide a positive backdrop for risk assets like stocks. If the Fed is raising rates or constraining liquidity, that activity tends to be a headwind for equities and other assets.

Stocks rallied in August when traders seized on Fed Chairman Jerome Powell’s post-rate-setting news conference comment that rates were in the range of “neutral,” while ignoring subsequent comments from Powell and various Fed governors that restrictive policy measures would be required. Market rhetoric shifted toward speculation about when the Fed might pivot to a looser monetary policy, questioning the Fed’s resolve to use all of its tools to fight inflation.

Last week at Jackson Hole, Powell gave a terse speech carefully crafted to leave no doubt about the Fed’s inflation-fighting resolve—even if economic output might be negatively affected. Traders certainly got that message. Time will tell whether the Jackson Hole speech was a true turning point, but it certainly jolted the market.

Another time-tested adage acts as a strategic corollary to “don’t fight the Fed.” That is “buy the dips; sell the rips.”

The idea of buying dips became firmly ingrained in investors during the post-Covid jump from mid-2020 through 2021. Many viewed it as a nearly foolproof strategy. What made it work was the flow of money unleashed by a combination of rate cuts, quantitative easing, and fiscal stimulus. None of these are forthcoming anytime soon. Thus, the opposite strategy from buying dips should have a greater likelihood of success. That is “selling the rips.”

This strategy involves either lightening up long positions into market bounces, using those bounces to hedge long positions with options, or speculating from the short side using stocks or derivatives. If you choose to hedge or speculate by buying puts, the tendency of implied volatility to rise when stocks fall can provide an extra boost.

Perhaps the best way to hedge an individual investor’s portfolio or to speculate on the downside is to use puts on the Invesco QQQ Trust Series 1QQQ –0.60%  (ticker: QQQ).

The Nasdaq 100NDX –0.64%  Index, which Invesco QQQ replicates, correlates well with the S&P 500SPX –0.58%  index but is typically more volatile. Traders with high conviction about a broad market move find that Invesco QQQ is more likely to have a greater percentage change than exchange-traded funds like the SPDR S&P 500SPY –0.54%  (SPY). Also, many individuals are overweight megacap tech companies that are even more dominant in the Nasdaq 100 than in the S&P 500. Invesco QQQ may be more representative of the portfolio that one wants to hedge.

For example, those who see a reasonable likelihood of a 10% decline by the end of the month might want to buy a $290 put on Invesco QQQ that expires on Sept. 30 while selling a $270 put for the same expiry to defray some of the cost. The outlay is about $3.50, which is also the maximum loss. The maximum gain would be $11.50 if Invesco QQQ trades at $275 or less at expiration.

For markets, the Fed is a 500-pound gorilla. Why battle such an adversary? “Don’t fight the Fed” should remain your mantra, while “sell the rips” offers a crude guide to strategies that keep you on the side of a restrictive central bank.

Originally Posted September 1, 2022 – As the Fed Raises Interest Rates, Let These 2 Mantras Guide Your Investing

Steve Sosnick is the chief strategist at Interactive Brokers.

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