As Interest Rates Change, Opportunities Arise

No doubt about it. Last year was nasty for investors in stock and bond mutual funds.

U.S. stock funds fell 1.69 percent. Taxable bond funds dropped 3.7 percent. No diversification strategy would have worked.

Even some legends in the mutual fund industry did poorly. Both Fidelity Investment’s Magellan Fund and Vanguard Group’s Windsor Fund finished in the red. Magellan didn’t even beat the averages.

But there was an alternative approach for mutual fund investors, one I’ve been watching for almost two years now. I say “watching” with regret. Following it would have been rewarding.

It is an investment strategy for stoics, in the classical sense: Pleasure is the absence of pain.

The alternative is the brainchild of William E. Donoghue, who holds a master’s degree from Temple University’s business school. He is author of Donoghue’s Moneyletter, an investment newsletter, and several books on mutual fund investing.

It’s something called Donoghue’s Signal Strategy. If you’d followed it last year, you would have made 4.2 percent on your investments. That’s not much compared to the double-digit returns of previous years, but it is better than last year’s averages.

I came across Donoghue’s successful formula a couple years back in one of his books called “The Donoghue Strategies.” The subtitle is “10 minutes a Week to Investment Success.” You can see what caught my eye. A quick, easy way to riches.

Price also was an attraction. I shelled out two bucks. The book was on a book store’s deep discount table. The cover price was $18.95. Already I felt richer and smarter.

Donoghue’s premise is simple. If you understand interest rates and their trends, then you can read the stock market. Booming stock markets go bust once interest rates rise. The Federal Reserve has choked off many a rising market.

Seems pretty obvious, huh? When the Fed starts to raise interest rates as it did last February, we should all duck for cover. But no M.B.A. worth his salt would advocate something so straightforward and Donoghue’s no exception.

His approach anticipates Fed action and the likely reaction. In fact, Donoghue’s approach gave a sell signal in Dec. 6, 1993, about two months before the Fed actually hiked rates.

Key to following the signal is something called the Donoghue’s Money Fund averages, which track the weekly average interest rates on money market mutual funds.

The signal involves the 25-week moving average of the seven-day uncompounded yield. The moving average is compared to the weekly number. If the weekly number is greater than the moving average, it’s time to move into money market mutual funds.

This is beginning to sound complicated. More time-consuming than 10 minutes a week. But it really isn’t so bad. You only need a starting point, the current signal number, which is available from IBC/Donoghue Inc. in Ashland, Mass. Call 1-900-773-4868. There is a $2 fee.

When the new seven-day average is released, you do a little math. The seven-day number is published weekly by Barrons and the Associated Press (available through Compuserve Thursday nights).

The 25-week average is multiplied by 0.925 and the seven-day yield is multiplied by 0.75. Then the two numbers are added to yield the new Signal. Of course, you can subscribe to Donoghue’s Moneyletter which gives the signal each week, but that will cost $127 a year.

The Moneyletter gives you not only the numbers but a nice graph. When the line representing the weekly number rises up through the one representing the average, that means you sell your stock and bond funds and move into money market mutuals.

Of course, you can draw the graph at home on paper or, if you have a computer with a spreadsheet and graphics, you can train it to do it for you.

The signal approach strikes me as particularly useful for a retirement account such as a 401-k or IRA. It also could be used with annuities that allow changes among investments.

As of Tuesday, the seven-day average stood at 5.43 percent, while the Donoghue Signal number was 4.72, meaning there is still quite a ways to go before the lines cross again and investors dive back into the market.

“Those people who are following the Money Dongohue Signal are going to be in money funds for a while,” says Michael Krasner, a Donoghue spokesman. `I don’t think they will be complaining about it because of the current yields.”

Indeed, many money market mutual funds now are yielding close to 6 percent. It’s easy income to take while waiting for the next safe move into stocks. Painless.