Alpha Power Investing Newsletter

January 20, 2012

The January Effect

We are now in the midst of the annual "power zone" - the time period which begins in late-October and continues through to early May. During this period, since 1949, the Dow Industrials have experienced an average daily appreciation which is 27 times greater than the other days of the year. Over the past 62 years, this period has experienced declines just 20% of the time, whereas the other period (which I call the "dead zone") has been down 45% of the time. Most importantly, for investors who want to avoid large declines, 80% of all the bear market damage has occurred during the "dead zone". In addition, this long-term "skewing" of returns into the "power zone" is a global phenomenon, occurring in over 30 developed stock markets world-wide.

While there are several causes for this remarkable tendency, one of the most important is the annual "forecasting cycle" which is based on some enduring facts about human nature. The annual forecasting cycle starts late in the year when investment "experts" begin to forecast corporate earnings, market returns, interest rates, etc. for the next calendar year. The investment public demands this kind of crystal-ball gazing and pays through the nose for it. The "experts" - employed by research firms, brokerage houses, mutual funds, insurance companies and hundreds of other investment enterprises - are articulate, sincere, intelligent, well-educated and very highly paid. Above all, however, they are extremely confident.

In general, they also tend to be overly optimistic - reflecting both a business necessity (who's going to buy when the news is bad?) and a flaw in human nature (why stick my neck out when most of the time things work out okay?). This expert optimism continues through the early part of the year until earnings and other financial data start becoming visible and trends emerge in early summer. Very often this requires the experts to revise their earlier estimates downward. Should this occur while other financial problems surface, the result is often a steep decline.

Stock market observers have known for years about the "January Effect". Early in the year, small-cap stocks generally outperform large cap stocks. This out-performance continues until late-May. The chart below graphically depicts this effect.

The Russell 1000 is an index of the largest public companies, whereas the Russell 2000 is an index of the smallest public companies. When the line is rising, small companies are outperforming large companies. As you can see, small companies start outperforming in mid-December and continue to do so until late-May.

This phenomenon is an artifact of the annual forecasting cycle. When investors are optimistic about the future, they are willing to take on more risk. During bullish cycles in the market, small companies tend to be market leaders.

This is why Alpha's Mid-Cap Power Index program, which attempts to exploit the annual forecasting cycle, is focused on the S&P 400 MidCap Index. This index is a quality-notch above the Russell 2000, but still sufficiently small to exploit the "January Effect". Should large-cap stocks take the lead during the "power zone" (it happens), mid-caps will participate more than small-caps.

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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