Alpha Power Investing Newsletter

December 3, 2009

Steamrollers and Politicians

I like the business model of a casino. Stack the deck in favor of the house, then just keep'em coming in. Owning a casino gambling operation is a no-lose proposition as long as the victims (er, customers) keep playing. The iron laws of probability are business partners with the house.

Unfortunately, investing in the stock market is not so simple. But, if you look hard enough, you can find ways to stack the deck in your favor. You just have to follow three rules:

  1. Be humble
  2. Don't pick up nickels in front of a steamroller
  3. Get help from politicians

Humility

This is basic. We tend to believe that we know things when we really don't. We listen to the news to find out what's likely to affect the stock market near-term. Big mistake. Name one talking head who's gotten anything important right. We read reports by famous, noble-winning economists. Another big mistake. Even if they're right about next year's economy, who knows what it means for the stock market. The market's perverse - it can go down a bunch while earnings are rising (See 1973-74, 50% decline). Besides, economists are herd animals, shy and cautious, and notoriously wrong.

Being humble means that we know that we don't know the ultimate meaning of all the complex factors affecting the market.

But we have to move forward anyway. We have to invest. We need an edge - something that's comprehensible, repeatable, fairly predictable, grounded in reality - that puts the iron laws of probability on our side.

Steamrollers

Don't pick up nickels in front of a steamroller. The risks are big, the rewards are slim.

We know that the market (the Dow Industrials) goes nowhere over time during the six months from May to November. An investment of $10,000 in the Dow during this period since 1949 is now worth about $7,000. A $10,000 investment in the other six months is now worth about $820,000. We also have a pretty good idea about why this happens - but that's another story. The market is up about 55% of the time during this six-month "dead zone", but these up periods are systematically wiped out by the down periods, some of which are doozy's (see 2001, 2002, 2008). Here's where humility comes into play. Since investing in stocks over the long term during the "dead zone" (which is half the time) is an almost guaranteed losing proposition, and being humble (which means we haven't the slightest idea when the ax is going to fall), our course is clear. We don't pick up nickels in front of the steamroller. Instead we bide our time in the arms of something safe - like short-intermediate bonds - until November rolls around again.

Politicians - Our Friends and Allies

There is an exception to every rule. The exception to the above occurs in the pre-election year of the four-year Presidential Election Cycle.

The pre-election year (year 3) is magic for the stock market. The Dow hasn't been down on a total-return basis during this period since 1931. The average return is 17% plus dividends. That's three times higher than the average for the other three years in the cycle. Actually, this blissful period begins just before the mid-term elections. The fourth quarter of the mid-term year (year 2) combined with all of the pre-election year has averaged a 25% gain plus dividends since 1931.

This is all due to the self-serving behavior of the political establishment. The mid-term elections mark a turning point in political behavior and rhetoric. The ruling party and all incumbents know that their chances of retaining power at the Presidential elections are dramatically diminished if the economy is in the doldrums. As Bill Clinton so aptly put it, "It's the economy, stupid!" Therefore, the Washington establishment shifts gears and now promises fiscal discipline, budget-cutting, de-regulation, tax-breaks and other investor-friendly legislation. Investors like this kind of talk and optimism builds. Often the Federal Reserve co-operates by lowering interest rates and increasing the money supply.

Over the past five election cycles, a portfolio divided equally between the S&P 500 and the NASDAQ 100 produced the following results during the five-quarter "sweet spot":

George Bush Sr. +57.9%
Bill Clinton I +42.1%
Bill Clinton II +107.3%
George W. Bush I +57.6%
George W. Bush II +19.7%

This is about as good as it gets. When Washington D.C. is for us, who can be against us?

The next election-cycle "sweet spot" begins October 1, 2010.

Back To The Casino
To sum up our business model:

  1. Be humble - don't try to figure out the economy.
  2. Don't pick up nickels in front of a steamroller - stay out of the market during the 5-6 month "dead zone".
  3. Except when politicians are on your side, then go for it.

Sincerely,
Jerry Minton, Ph.D.
President

© 2009 Alpha Investment Research Inc.
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