Interest rate policy a proven stock market investment tool

Stock market investing can be, and is probably always a rat race. Often, a race to beat a market benchmark, and other competing asset classes.

Over the centuries, investors have devised many tools to achieve this. Some market watchers were even known to employ eccentric stock market indicators, primarily to measure the overall morale of the investing population—and thereby formulate an investing strategy.

Some of the indicators are almost ludicrous. Take women's hemlines, for instance. Some market watchers believed that as hemlines rise, so does the stock market.

Consider the roaring 1920s when women wore short flapper skirts and a stock market rise followed. When the market crashed during the great depression, long, modest skirts followed.

So the hemline index implies that as people become more exuberant, stock prices rise and clothing becomes more daring and as society becomes pessimistic, people become more conservative with their clothing and investment choices. Some have even considered lipstick sales. The story goes that when the market is down, women buy cheaper brands.

And golf is not left out. Broadly, it was assumed that by observing certain changing patterns, an investor could get a clue into market direction. Today, investors, both institutional and retail, can choose from two main strategies to generate returns in their portfolio: active and passive management.

Active management aims to outperform the market compared to a specific benchmark, while passive management mirrors the investment holdings of an index and its performance. If you find the rat race too pacey and chaotic, the passive approach is for you.

Some strategies can also be sector specific. A case in point is banks. They have been known to track interest rate cycles, making the latter a stock market indicator. Indeed, the Wave theory on interest rate cycles postulates that investors should buy bank shares when they expect a declining interest rate environment, and conversely, sell bank shares in anticipation of a rise in interest rates.

A couple of months back, I set about to test this theory on local bank stocks over a decade, using monthly data.

To represent bank stock prices, I created a simple market-capitalisation weighted index consisting of 10 bank stocks (and which I designate as the Banking-10 Index).

On the interest rate front, I used the Central Bank Rate (CBR), the monetary policy signal. Results for the period between 2009 and 2016 indeed show sensitivity of bank stocks to interest rate cycles, with three observable response cycles.

In the first cycle, a loose monetary policy posture between December 2008 and May 2011 saw the index gain 120 percent in value, trough-to-peak. In the second cycle, a tightening stance between September 2011 and June 2012 saw the index shed 37 percent of its value, peak-to-trough.

In the third cycle, a subsequent easing posture, which began in July 2012 and lasted until May 2015, saw the index gain a staggering 178 percent between December 2011 and March 2015, trough-to-peak.

These cycles lend credence to two schools of thought: (i) empirical studies which have shown that the stock market is an important monetary policy transmission channel in Kenya (Mwega, 2014; Cheng, 2006); and (ii) a simple rule on US Federal Reserve (Fed) monetary policy by Edson Gould, a legendary technical analyst from 1930s through the 1970s, in which he posed that whenever the Fed raises either the funds target rate, margin or reserve requirements three consecutive times without a decline, the stock market is likely to suffer a substantial setback.

Consequently, interest rate policy should still be part of any investment toolkit. However, as observed in 2018, a dominant fiscal policy presents significant reversal risks.