Alpha Power Investing Newsletter

November 13, 2012

The Power Zone

We have now entered the annual "power zone" which stretches from roughly late-October to mid-May.

Academic investment theory states that there are no trends in the stock market that can be exploited for profit. The market, it is said, is random except for very long-term appreciation which occurs over decades. This point of view ignores the fact that "the market" is people. Human behavior is not random. In fact, crowd behavior is quite predictable.

Granted, one cannot predict the economic and political events that will occur over time which will produce an effect on the market. But, one cannot predict the individual play in a game of blackjack either. Yet we know that the dealer in blackjack has a statistical advantage and that the odds of the game are stacked against the player. Casinos are great businesses which are built on the predictability of human behavior and a knowledge of probability.

Our claim is that investors can be just like casinos, exploiting human behavior and the laws of probability.

Let's begin with a couple of well-known facts about investors. First, we know that investors dislike uncertainty. Next, we know that investors believe that there are investment "experts" who can diminish uncertainty and risk by way of their superior knowledge and/or skill. Wall Street responds to these two facts by providing an army of experts in just about every investment category. These experts are impressive in their credentials, their confidence, their sincerity, and their wide experience.

The only problem is that investment experts are systematically wrong and worthless over the long-term.

Investment gurus are not like surgeons or engineers or dentists or auto mechanics. There is no settled science or body of knowledge to rely on. The factors that drive the prices of individual stocks up and down are vast and constantly changing. To suppose that one mind can capture it all, analyze it, and do it consistently is simply not possible. Corporate insiders do it best, but then they are willing to wait years, even decades, for a payoff. Wall Street doesn't have that kind of patience.

The experts are conflicted - their research sells when they are bullish on a company and ignored when they are bearish.

The upshot is that expert forecasts of earnings tend to be overly optimistic and this predictable behavior can be exploited for profit long-term. Over time, we should be able to see a pattern in the data which results from this behavior. To be more exact, we would expect more investor optimism at year-end since they are making decisions about the next calendar year. This optimism should persist in the early part of the year when there is little real information about earnings. As the year progresses and information becomes available, we would expect a decrease in investor optimism as the over-optimistic forecasts of the experts crashes against the emerging earnings reality.

And that is exactly what we find in the long-term data. Since 1949, between November and May, the Dow Industrials has enjoyed an average daily appreciation that is more than 27 times greater than the average daily appreciation of the other six months of the year. The annualized rate of appreciation during this six month "power zone" has been 16.3%, whereas the annualized rate of appreciation from May to November has been negative. Moreover, this 62 year pattern is global, occurring in over 30 developed markets - just as you would expect if the cause was a fundamental factor of human behavior.

Since the market high in early 2000, the S&P 500 has returned less than T-bills. Over the past 12 years the market has been slowly working off the excessive valuations of the late-90's. In spite of this lengthy drip-torture, stocks are still in the top 20% of historical valuations, implying that things are not going to change anytime soon. Yet over this dismal epoch, the market's power zones (November to May for the S&P 500; November to June for the S&P 400) have been a bastion of relative strength. The chart below shows the indexes vs. their respective "power zone" returns since 2000 (dividends included).

Naturally, holding bonds during the "dead zone" would push the returns of the power zones much higher.

During periods of overvaluation, reducing market risk is essential to long-term, robust growth of assets. That's why we advise our clients to avoid the "dead zone" and accept market risk only when the long-term probabilities puts the wind at your back.

Sincerely,
Jerry Minton, Ph.D.
President
1-877-229-9400, Ext. 11

Past performance is not a guarantee of future performance.

 
© 2012 Alpha Investment Management, Inc.
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