Alpha Power Investing Newsletter

December 3, 2010

Unnecessary Risks

If you're in retirement or about to retire, you should remind yourself of the first rule of investment: take no unnecessary risks.

The application of this rule will vary from person to person depending on their financial circumstances and income requirements, but there is a universal application for any investor who is counting on the stock market to preserve purchasing power during retirement.

Continuous exposure to the stock market is unnecessary for the achievement of long-term market returns. Indeed, under several scenarios, continuous exposure to stocks guarantees that investors will not achieve the long-term returns of the market.

Many investors today are "in the market" in one form or another (mutual funds, separate accounts, wrap programs, personally selected stocks) believing that their long-term returns will be around 10%. Some investors argue that because the past decade has done so poorly, the next decade must be above average, producing returns considerably higher than the long-term average of 9.5%. These investors are in for a big disappointment.

Knowledgeable investors know that market returns are driven primarily by earnings valuation and dividends. Today's market has a historically low dividend rate (1.8% average) coupled with a historically high earnings valuation. The S&P 500 now sells at 22x the ten-year inflation-adjusted earnings average, one of the highest valuations of the past 130 years (only surpassed by 2007 and 1998-2001). No long-term bull market in U.S. history has ever begun from such high valuations and low dividend yields. In fact, every major long-term bear market (1900-1921, 1929-1942, 1968-1982, 2000-2008) has begun from valuation levels comparable to today's.

If you're about to retire or in retirement, you should know that continuous exposure to the stock market under these circumstances is a bet against history - a bet that "this time is different". The fact that the past ten years has been lousy is irrelevant.

So what's to be done? How can you achieve meaningful returns above inflation and control risk at the same time?

The answer comes with the realization that the market is not random. Stock market returns are not scattered randomly across time. There is a long-term statistical pattern to the distribution of returns across the calendar year. I call it the "skewing" of returns into the annual "power zone". For large cap stocks the power zone runs from November through April. For smaller cap stocks, the zone is extended for a month. During the six-month "power zone", the average daily return of the market (Dow Industrials) is 27.5x greater than the rest of the days of the year (since 1950).

Let me say that again: Since 1950, stocks have appreciated at a daily rate that is 27.5x greater during the six-month power zone than the other days of the year. You should also know that 75% of all market losses have been contained in the other six months, which I call the "dead zone".

To see the practical effect of this phenomenon, let's construct three indexes based on power zones. The first we'll call the Alpha Dow. It's constructed by holding the Dow Industrials (with dividends) from November through April, then holding the Barclays Capital Intermediate Treasury Index the other six months. Next is the Alpha 500, constructed the same way using the S&P 500 Index. Finally, we'll construct the Alpha 400 by holding the S&P MidCap 400 Index from November through May, then the Barclays Capital Intermediate Treasury Index the rest of the time. We'll compare these strategies with the indexes held continuously over time. Keep in mind that these strategies involve 40%-50% less risk every year than the continuously held indexes.

As you can see, over the past ten years our "power zone" indexes have dramatically outperformed their "continuous" counterparts. What is especially noteworthy is the performance of the S&P MidCap 400 Index and its "power zone" variation. Since 1981, when the S&P MidCap 400 Index was created, it has delivered a 35% annual return premium to the S&P 500. In the last 30 years, the Alpha 400 has had one down year - down 6.7% in 1994 - with an annualized return of 18.2% since inception. This is a remarkable long-term record for a strategy that has 40% less risk each year than the market.

Many investors are concerned about inflation in the future, due to the extraordinary expenditures and growth of the federal government over the past ten years. Gold, which has historically been a good barometer of inflation, is signaling that inflation is "in the cards". How does our "power zone" strategy work during inflationary times?

The last high inflation period lasted from 1971-1982, a period that saw the Dow Industrials go nowhere while interest rates climbed relentlessly. Over the course of that eleven-year period, the Dow appreciated 102% during the power zones, and dropped 42% during the other six months. Add in dividends and the returns from intermediate treasuries and you get a winning wealth preservation strategy during one of the worst inflationary periods of the past 100 years.

Retirees are currently facing an investment puzzle that cannot be solved conventionally. Bonds are probably near the end of their virtuous cycle and will not provide the same high returns as in the past. Stocks are overvalued and near the top of their risk cycle, with perhaps another dismal ten years in store.

What will serve as the "growth engine" for protecting retirees' purchasing power? My solution is to exploit the annual "skewing" of returns that has been systematically going on in the U.S. and in more than 30 foreign markets since World War II.

To understand the causes of this global effect, read our brochure on the Mid-Cap Power Index Managed Account at the Programs and Performance section of our website at www.alphaim.net.

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


Disclosure: Past performance is not a guarantee of future performance.

© 2010 Alpha Investment Management Inc.

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