Alpha Power Investing Newsletter


January 27, 2011

Emerging Bubble

Wall Street has its teeth in a concept. Watch out. The lemmings are gathering and growing fatter every day. The investment concept du jour is emerging markets.

The promotional patter goes something like this: Emerging markets like China, India and Brazil are great investment opportunities because their economies are growing rapidly (GDP growth is double or triple that of the developed world). Their populations are large, young, hard-working, and poor - which means great consumer demand far into the future. And, oh, by the way, look at the returns from these markets for the past 10 years - phenomenal!

Now for any investor who is looking over five or ten year time frames for investment satisfaction, there is an obvious problem with the above patter; namely, what does any of it have to do with the future performance of their stock markets?

As far as I'm aware, there is no meaningful long-term correlation between GDP growth and returns of the stock market. There may even be a negative correlation over significant time periods if you begin your involvement after a big run-up in prices and at a moment when these markets are expensive.

The emerging markets peaked in 2007, along with the U.S. market, then got slammed hard in 2008 - harder than we did. They are now in a strong recovery and will probably continue up along with the U.S. market and the developed markets as long as the U.S. Fed keeps our interest rates in the basement.

It is far better, to my way of thinking, to avoid the extreme volatility of these markets if one can get robust returns without the risks. This brings us back to the theme of past several newsletters: Take no unnecessary risks.

So I decided to compare the Alpha Mid-Cap Power Index to the emerging markets indexes over various time frames to see what lessons, if any, were to be found.

If you remember from our recent newsletters, the Alpha Mid-Cap Power Index is constructed from two indexes, using a simple linking rule: Own the S&P MidCap 400 Index from November 1 to May 31, then own the Barclays Capital Intermediate Treasury Index from June 1 to October 31. The index is designed to capture the "skewing" effect that occurs over time. This effect, in which robust stock returns tend to occur between November and June (for mid-cap stocks, November through April for large-cap stocks), and market corrections tend to occur during the other months. To discover the cause of this effect, please read our brochure about the Alpha Mid-Cap Power Index Managed Account available at the Programs and Performance section of our website.

The chart below shows the comparison of the Morgan Stanley Emerging Markets index, the Latin American index, the Lipper Emerging Markets mutual fund average return, the S&P 500, the S&P MidCap 400 index, and our Power Mid-Cap index. The time frame of five years highlights the relative volatility of each index.

As you can see, the average emerging markets mutual fund (Lipper) underperformed the Emerging Markets index. This is normal. You can also see the risk that accompanied this asset class, with both the index and the Latin American index suffering declines in excess of 50% in 2008. Over the entire period, the Alpha Mid-Cap Power Index had about the same return as the Emerging Markets index, but with no significant losses.

The picture changes if you take a somewhat longer view. The following chart covers the eight years starting just after the 2001-02 bear market.

What a difference! The powerful bull market in emerging markets dwarfed conventional indexes, including the Alpha Mid-Cap Power Index. Of course, an investor would have had to dodge the preceding bear market to have the money and the nerve to jump in.

So, what about the 2000-02 bear market? How does it change the picture?

Over the eleven year period, the Alpha Mid-Cap Power Index suffered no down years, with an annualized return of 13.8%, compared to a 10.9% return for the Emerging Markets index, and a 0.4% return for the S&P 500.

Most investors really cannot tolerate the volatility associated with emerging markets, and those who can, tend to limit their investment in this sector to a fairly insignificant portion of their total portfolio. As far as I'm concerned, it's an unnecessary risk which requires exquisite timing of buying and selling to generate a return superior to our power index.

These markets are very popular right now and are probably in a "bubble" which will burst in a few years. Jeremy Grantham of GMO, who I regard as one of the top strategic thinkers of the current investment world, has done extensive research into bubbles - hundreds of them internationally in real estate, stocks and commodities. His research reveals that bubbles take as long to unwind as the time required to develop. Using this rule, we can estimate that the emerging markets bubble will take more than eight years to unwind from top to bottom, assuming the end is just around the corner.

More to the point, why try to time this monster? The Alpha Mid-Cap Power Index takes market risk only during the most robust periods of every year and hides in conservative bonds the rest of the time. Since 75% of market declines since 1950 have occurred during the "dead zone" each year, I'm inclined to say that our index has at least 50% less risk than the market and almost all equity mutual funds. To me, it's fairly simple: Why accept double the risk for significantly lower long-term returns?

Our Alpha Mid-Cap Power Index Managed Account seeks to replicate the returns of the Alpha Mid-Cap Power Index over time, net of fees and expenses. To achieve this, we use several "enhancements" to add returns safely to the base returns of the index itself. You can read about them in our brochure available at the Programs and Performance section of our website at www.alphaim.net.

If you would like to discuss this program, please call me at 1-877-229-9400.

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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