Alpha Power Investing Newsletter

November 5, 2009

Guaranteed to Lose

I'd like to introduce you to a losing strategy. No, I'm not crazy. The losing strategy I'm about to describe is something that every investor should know about - if only to avoid it.

I'm going to tell you about an investment that has lost money over the past 5, 10, 15, 20, 30 and 50 year periods. Had you invested $1,000 in this idea in 1949, you'd be down about 30% today. In fact, the last time your investment was above water was in 1970.

The name of this investment is the Dow Jones Industrial Average from early-May to November 1.

This six-month period has been a waste of time and money for the long-term equity investor since the end of World War II. Over the past 60 years, the market has been up just 55% of the time during this six-month "dead zone", which has suffered about 80% of the bear market damage since 1950.

During the other six-month period, from November 1 through early May, the Dow has appreciated at a daily rate 27 times greater than all other days, averaging a 17.7% annualized return. I call this the annual "power zone".

Continuing to hold stocks during the "dead zone", whether in the form of mutual funds, index funds, or privately managed accounts, represents a systematic "drag" on performance of 1%-4% annually, depending upon the relative market climate.

When you add in the positive returns that an investor could have enjoyed by being in intermediate government bonds during this period, the annual long-term loss becomes even greater.

So why does the market follow this pattern? Researchers have postulated a world-wide "optimism cycle" which affects the U.S. market and over 30 other developed markets in Europe and Asia.* The "optimism cycle" is caused by the forecasting industry - the legions of economists, stock analysts, and other forecasters who deliver predictions about the economy, stock earnings, commodity prices, etc. to investors trying to see into the future.

The important fact to digest about this army of "experts" is that they are spectacularly wrong most of the time. In addition, they are wrong in a predictable fashion - they are far, far too optimistic in their annual forecasts.

The "optimism cycle" runs like this: Late in the calendar year, stock analysts make their annual predictions about next year's earnings for the companies that they follow. Likewise, Wall Street economists and gurus make predictions about economic growth and stock market returns. These predictions are almost always too optimistic. Importantly, there are few contrarian voices - these "experts" tend to flock together. This uniformity of positive opinion offers support for the market late in the year.

As the new year unfolds, the too-optimistic forecasts are maintained even in the face of contrary evidence. Excuses are made and projections are moved forward into the next quarter. At some point, however, realities have to be faced and earnings estimates are "adjusted downward". This reaches a crescendo in the third quarter, especially September, when the earnings picture for the year becomes much clearer. The market tends to suffer as a result.

As you might expect, "downward revisions" affect speculative stocks more than blue chips. Using the Russell 2000 small-cap index as a model, the four-month period from July 1 to November 1 has been down 17 times since the inception of the index 30 years ago. A $1,000 investment in the Russell 2000 during these four months has lost about half its value since 1979, a negative 2.4% compound rate of return. During the other eight months, the index has produced a 12.9% average return with just five down periods. Imagine the 30-year return of the Russell 2000 with the 2.4% negative drag replaced by positive returns from conservative bonds (see the Power Index section of our website).

Here's the bottom line: If you have a retirement plan, IRA or 401k account, or any other diversified equity account, you can count on the five-six month "dead zone" to be a losing proposition over the long term. Remaining invested during this period is costing you 1%-4% annually in long-term "drag" plus 1%-3% in lost interest from intermediate government bonds, depending on the prevailing interest rate climate. In effect, you are trying to run a marathon while carrying a 50-pound sack of cement.

My recommendation: Put your tax-deferred accounts on a diet - drop the weight. There are no tax consequences. By avoiding the "dead zone" (we identify it as June 1 - November 1), you take 40% less risk (using low-risk, intermediate treasury bonds as a substitute) and you replace long-term negative returns with generally positive returns. Historically, over the past 30 years, this has resulted in a 40%-50% increase in annual returns using the major market indexes (Dow Industrials, S&P MidCap 400, Russell 2000 Index). Since index funds outperform the majority of comparable large-cap, mid-cap, and small-cap mutual funds, even without this adjustment, the real-world gains are substantial for such a simple annual decision.

Our research finds that mid-cap stocks respond most favorably to this strategy. Using the S&P MidCap 400 Index as a model, the simple replacement of the index for five months (June-October) by the Barclays Intermediate Treasury index, has produced gains for 27 out of the 28 years that the index has been in existence. (See Alpha Mid-Cap Power Index in the Power Index section of our website).

Best of all, it was up in 2008. It doesn't get much better than that.

*Doeswijk, Ronald, 2004, The Optimism Cycle: Sell in May, IRIS (Rabobank/Robeco), the Netherlands

Jerry Minton, Ph.D.

© 2009 Alpha Investment Research Inc.
Alpha Power Investing Newsletter Archives