Alpha Power Investing Newsletter

February 15, 2011

Following the Script

The historical stock market patterns associated with the presidential election cycle are emerging in full force.

If you remember, the four-year election cycle has a fifteen month period, beginning one month before the mid-term elections and ending on the last day of the pre-election year, which I call the election cycle "power zone". This fifteen month period has not suffered a loss (Dow Industrials, total return) since 1931, averaging about 29% (with dividends). During this period, the Dow appreciates at a daily rate that is 7x greater than the rest of the days in the cycle. In fact, if you remove this fifteen month "power zone" from the historical record of the Dow since 1931, you get a return of about 1% annually.

The cause of this phenomenon is politics pure and simple. The mid-term elections mark a significant turning point in the political rat race. Politicians now prepare for the next presidential election, which means a new set of promises and a different kind of posturing. Gone are the grand schemes for improving our lives and expanding the bureaucracy. Now the name of the game is jobs, economic growth, prosperity, fiscal responsibility, and eliminating the frivolous in government. This mostly hypocritical reversal sells well on Wall Street and the stock market is temporarily revitalized.

Several of our investment programs capitalize on this change in market climate. Both the E-System Portfolio and The FormulaTM are fully invested during the election cycle "power zone" and portfolios are evenly distributed between the S&P 500 and the NASDAQ 100. The chart below shows the result of this policy over the past five power zones and first quarter of the current power zone.

As you can see, even without earning interest during the interim periods, this policy has generated returns significantly higher than the market itself with a fraction of the risk. In the fourth quarter of 2010, the policy delivered an 11% return, about the same as the S&P 500.

If you combine this strategy with a conservative bond program during the "off" months, you get our E-System Portfolio, a remarkably smooth and consistent long-term growth strategy. Combining the strategy with our Mid-Cap Power Index program produces The FormulaTM, a slightly riskier and more robust growth strategy.

The market today is in a full-blown bullish stage. While corrections are to be expected, they will probably be sharp and short-lived. I expect the bullish phase to last well into the election year.

The big picture, however, is not so bullish. If you think that this is the beginning of a long-term bull market like the 80's and 90's, you are going to be disappointed. Investors who stay continuously invested in stocks will pay a steep long-term price for their optimism.

As of today, the Shiller PE is 24. The Shiller PE is the ratio of the S&P 500 to ten year average earnings, adjusted for inflation. This valuation marker, developed by Professor Robert Shiller of Yale, has a theoretical history going back to 1870. It has an excellent record of marking major, long-term turning points in the stock market. Today's valuation has rarely been exceeded in the past 130 years, except for a brief time in 1929 and in the market bubble of 1998-2001. This level of overvaluation has always been associated with poor or negative long-term returns for the market. To argue, as some advisors and money managers currently do, that we are in a long-term bull market, requires that future valuations consistently exceed those of 1929 and 2000. This is pure fantasy.

This elevated valuation does not mean that investors cannot make good returns from exploiting an overvalued market - witness the returns of the Alpha Mid-Cap Power Index over the past 15 years.

Legend: The Alpha Mid-Cap Power Index is constructed by holding the S&P MidCap 400 Index from November 1 to May 31; then holding the Barclays Capital Intermediate Treasury Index from June 1 to October 31.

It does mean, however, that exposure to stocks beyond the known factors that enhance the market climate temporarily, is likely to result in poor to negative returns. Investors who wish to control risk in their portfolios must become part-time in the market. Diversification into foreign markets or other equity sectors (small cap, high yield dividends, etc.) will not have a substantial protective effect because overvaluation is present almost everywhere (unlike 2000 when real estate, value equity and commodities were still cheap).

The bountiful market that we are now experiencing will not last. Exactly how its demise will come about is unknowable. The odds are that our programs, which accept risk only during high-probability time periods where the causes of above-average returns are well-known and persistent, will navigate the future with rewarding total returns.

If you would like to discuss any of our investment programs, please call me at 1-877-229-9400.

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

Past performance is not a guarantee of future performance.

© 2011 Alpha Investment Management Inc.

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