Alpha Power Investing Newsletter

November 7, 2011

Friendly Rates ... Goodbye

In 2011, the 30-year U.S. Treasury Bond fell below a 3% yield. Some forecasters are predicting that a 2% yield is in the cards over the next several years. They point to a time in the late 1800's when the construction of the railway system throughout the West caused a massive debt pileup, leading to 2% long-term yields for over a decade. Japan, following standard Keynesian protocol for the last 20 years in an attempt to boost its economy has created massive government debt and 2% long-term rates.

The Federal Reserve has announced that it plans to keep short-term rates near zero through 2013. Recently, the Fed has also initiated a policy called 'Operation Twist', which is designed to lower rates on long-term debt.

Meanwhile, U.S. consumers and corporations are paying down debt in the face of high unemployment, slow growth, collapsing house prices, and millions of underwater mortgages. Throw demographics into this mix - aging boomers coming into retirement with no desire to increase their debt - and it's hard to see how interest rates can possibly increase substantially for the next several years.

In short, we are in a global de-leveraging cycle which could last far longer than anyone expects.

In this environment, the quest for income by conservative, low-risk or no-risk investors becomes a monumental headache. In fact, real, after-inflation, after-tax returns using conventional savings devices (CD's, Treasury Bills, etc.) are impossible now and things are not likely to get better.

The upshot of all this is that more and more investors are being pushed into more speculative, riskier assets such as the stock market. This is, of course, exactly what the Federal Reserve intends, under the curious assumption that an overvalued stock market increases confidence and encourages spending by consumers and investment by corporations.

Any way you look at it, it seems to me that the Fed is pursuing this economic experiment on the backs of savers and the elderly.

The bottom line is that fixed-income investments with blue-chip credentials will not provide the return to investors that they have over the past three decades. The long cycle of declining rates, which gave bonds long-term returns comparable to stocks over the past 30 years, is essentially over or nearly so.

Looking out over the next five or so years, the main driving force behind portfolio returns will be how ably investors can negotiate the up and down cycles of the stock market. Naturally, the vast majority of investors will fail the test since empirical studies have shown that the typical investor does much worse than the market (Dalbar, Quantitative Analysis of Investor Behavior, 2011. Also see the last Alpha newsletter).

So how does an investor go about the task of avoiding substantial losses and exploiting the future up-cycles of the market?

Let's start by looking back to the end of World War II and asking whether there are any reliable long-term patterns in the stock market's gyrations. As it turns out, there are. Statistically, over the past 62 years, there is a clear pattern of the "skewing" of returns into the six-month period from November to May. Since 1949, the average daily return of the Dow Industrials in this six months has been 27.4 times greater than the average daily returns during the other six months of the year. In fact, an investor who kept his money in the Dow for the entire 62 years in just the six months from May to November would have less today than the starting value (appreciation only). On the other hand, an investor only owning the Dow from November to May over the same 62 years would be up over 5200% (appreciation only).

The reason for this vast discrepancy in returns lies in the fact that 80% of bear market damage over the entire period occurred in the May to November time period. As long-term readers know, my own explanation of this phenomenon, which is global (occurring in over 30 developed markets worldwide), is that it is a result of human nature.

As the popularity of the stock market grew after World War II, the investment industry responded to investor demand for "experts". Investors, always attempting to overcome uncertainty, want expert assistance in forecasting the earnings of the companies in the market. The wide demand for "analysts" and other pundits created a vast army of forecasters who thrive on the common assumption that disciplined, intelligent, experienced, confident "experts" can somehow find the key to successful stock picking and large profits.

Alas, it isn't so. By the early 1980's the evidence that expert opinion added nothing of value in the aggregate led to the rise of "indexing" as an investment philosophy. Academic studies over the past 40 years have built up a vast trove of evidence that indexing beats active stock picking over the long-term at the portfolio level.

Yes, there are exceptions, but it takes such a long time to recognize real skill, as opposed to the various forces that can make a lucky manager look smart, that often these infrequent geniuses are ready to retire just at the point of recognition.

In spite of all the evidence, however, investors still demand "expertise." This will never change. Somebody has to "make" the market in individual stocks and therefore there will always be big winners and big losers at the individual stock level, but rarely at the portfolio level.

Toward the end of the year, professional forecasters make their estimates for the next year's earnings. These estimates usually err to the optimistic side, causing investor hope to rise. The experts continue their enthusiasm for the first part of the calendar year, but as time goes on, the true nature of earnings begins to emerge. Late summer and early fall find previous earnings estimates frequently downgraded, causing a pause or a decline in the market. The period from May to November has been down 45% of the time since 1949 as a result.

The long-term skewing of returns into the November to May period presents an investment opportunity for conservative investors. This effect is more pronounced in small/mid-cap stocks than in the blue chips.

The mid-cap index was created by Standard and Poor's in 1981. It consists of 400 companies, all profitable, between one billion and nine billion dollars of capitalization. These companies are reviewed by S&P each year and the index is rebalanced as stocks move in and out of the capitalization range.

On its own, the mid-cap index has outperformed the S&P 500 by about 40% a year since its inception. This annual, long-term advantage can be increased by simply holding the index from November through May each year and holding intermediate treasury bonds for the remaining five months. We call this the Mid-Cap Power Index. Over the past 30 years, this tactic has added about 4% a year to returns, resulting in the following comparisons:

In the illustration above, beta is a measure of volatility. As you can see, the Mid-Cap Power Index has been about half as volatile as the S&P 500 over the past tumultuous decade. Also, note that this strategy has captured almost all of the market's upside returns while suffering less than 30% of downside returns.

The Alpha Mid-Cap Power Index Managed Account seeks to duplicate the results of the Mid-Cap Power Index after fees and expenses. For more details about this tactical strategy, go to the Programs and Performance section of our website at www.alphaim.net and click on the corresponding link to read the brochure.

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

Past performance is not a guarantee of future performance.

 
© 2011 Alpha Investment Management, Inc.
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