Alpha Power Investing Newsletter

December 16, 2011

The Big Skew

Long-term readers are familiar with our research showing how returns are influenced by the annual forecasting cycle. This cycle, caused by investor behavior in response to professional earnings forecasts at year-end, skews returns, over time, into the late-October to late-May period. During this period, the average daily return of stocks is over 20 times greater than the average daily returns during the rest of the year (Dow Industrials, 1949-2010). The flipside of this phenomenon is that 80% of major market declines are focused in the "dead zone", the period encompassing June through October.

The following chart shows the 25-year history of this effect on the three principal stock market sub-divisions.

As you can see, the effect increases as you step down from large-cap stocks (S&P 500) to mid-caps (S&P 400) to small-caps (Russell 2000). Actually, the small-cap effect is especially pronounced since the small-cap "dead zone" is just four months long, extending from July to November.

The practical upshot of this research is that long-term risk-averse investors should avoid the "dead zone" in stock indexes, waiting them out in bonds instead.

In addition to this "annual skewing", there is a much larger, multi-decade skewing of market returns caused by valuation. I call it "The Big Skew".

Let me propose a statistical investment experiment to you. Let's look at every possible three-year return in the U.S. stock market - measured as of each month-end - between January 1884 and June 2009. This period encompasses 1,506 observations over rolling 36-month holding periods.

The investment industry uses this data to convince you that a typical investor, holding a market index for at least three years, would have the following rational expectations:

  1. An annualized return, including dividends, of around 9.5% on average.
  2. Around a 15% probability of losing money over three years.
  3. A remote possibility of tripling the investment.
  4. A remote possibility of losing 80% of the investment.

These expectations are founded on the presumption that the distribution of returns over time is random. In other words, the hidden assumption is that any starting point in the series is statistically equivalent to every starting point.

Thanks to recent research by Keith Goddard, CFA, President/CEO of Capital Advisors, the statistical sleight-of-hand embodied in the long-term data has been exposed.*

Goddard wanted to see how valuations affected subsequent returns and used the Shiller P/E Ratio as the valuation marker. The Shiller P/E Ratio was designed by Yale economist Robert J. Shiller. It is calculated as the price of the market index divided by the average inflation-adjusted earnings for the index over the previous ten years. It is designed to smooth out the short-term swings in corporate earnings caused by economic cycles.

Goddard segmented the 125-year history of the market index into quartiles based on the level of the Shiller P/E Ratio. He then measured the return distributions associated with the highest and lowest quartiles. Here are the results:

* "Return Distributions and the Shiller P/E Ratio", Advisor Perspectives, February 2, 2010.

Today, the Shiller P/E stands at 20.3. I wonder how many investors would consciously invest in the stock market today if it were presented to them that statistically they had an almost 30% chance of losing money over three years in order to get an average 7% return?

Goddard's data reinforces common sense: When stocks are cheap, they deliver higher returns than when they are expensive. Unfortunately, stocks are not cheap today. That's why risk-averse investors need an insurance policy on their market exposure.

One of the best ways to hedge your long-term market exposure is to invest only during the annual "power zone", the six to seven month period beginning in late-October. Over the past 62 years (since 1950) this policy would have avoided 80% of all bear market declines.

The chart below shows the 25-year history of the Mid-Cap Power Index vs. the S&P 500 and the S&P 400.

The Mid-Cap Power Index is constructed by holding the S&P MidCap 400 Index from November 1 to the end of May; then holding the Barclays Capital Intermediate Treasury Index during the "dead zone". As you can see, long-term, there is no contest. Furthermore, over the past 30 years the Mid-Cap Power Index has never suffered a bear market and just one annual decline of 6.7% in 1994. Best of all, over the past 11 ¾ years, while the S&P 500 delivered a negative 4.5% cumulative return, the Mid-Cap Power Index was up 375.8%. This was achieved by avoiding two major bear markets and participating in about 90% of the market's gains over the period.

The Big Skew has been working against traditional buy-and-hold investors since 2000 and continues to degrade multi-year equity returns today and into the foreseeable future. Alpha's Mid-Cap Power Index Managed Account seeks to match the returns of the Mid-Cap Power Index after fees and expenses, providing investors with the hedge against market risk needed during periods of high valuation.

For more information about this strategy, go to the Programs and Performance section of our website at www.alphaim.net and click on the link for the Alpha Mid-Cap Power Index Managed Account 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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