Alpha Power Investing Newsletter

February 28, 2012

January Prognostications

One remarkably consistent stock market forecasting tool is the behavior of the market during the month of January. Jay Kaeppel, author of "Seasonal Stock Market Trends" (Wiley, 2009), has a January barometer with an uncanny predictive history.

Kaeppel's barometer, which I will call "Jan K", is computed as follows (using the Dow Industrials):

     If the first five days of January are up = +1
     If the last five days of January are up = +1
     If January as a whole is up = +1

The barometer's tally then predicts the returns for the remainder of the year: February 1 - December 31.

As you can see, the higher the barometer score, the higher the historical returns. A score of +3 has produced higher returns than all the other January's combined.

How does this barometer work in presidential election years?

In 2012, January was up the first 5 days, down the last 5 days, but up as a whole, giving us a Jan K score of +2. Whew!

So far, the market is playing out the usual seasonal tendencies. As of this writing, mid-cap and small-cap indexes are leading the charge early in the year. This should continue until late-April, early-May.

It is important to remember that in spite of the strong Jan K barometer, and in spite of the strong opening performance of the stock market, we are still in a financial environment manipulated by the Federal Reserve. The Fed's stated objective is to keep interest rates so low that investment funds move into speculative arenas, like the stock market, searching for higher yields and meaningful total returns. The presumption is that this support under the stock market will lead to greater business and investor confidence, which combined with lower borrowing costs, will produce a robust recovery from the 2008-2009 recession.

As I see it, there are two problems with this approach. First, I believe that we have entered a global de-leveraging cycle which will prevent any great new debt accumulation in the private sector. Corporations, like individuals, have been pushed to the edge of the cliff by debt and have taken the pledge to never go there again. This unwinding of more than three decades of debt accumulation will require many years to work out. The bottom line is that the U.S. consumer will not drive the economy by increasing debt as they have in the past.

The second problem is stock market valuation. As I have pointed out several times recently, the U.S. stock market is not cheap. In fact, it is currently valued in the top decile historically (1880-2012). This puts a lid on long-term gains and insures that returns over the next decade will be below the historical average. This trend will be accentuated naturally by the lower growth of the economy caused by consumer and business de-leveraging.

These two circumstances mean that investors in the stock market who pursue a buy-and-hold strategy will not be rewarded by their perseverance. Every long-term bull market in U.S. history has begun from the lowest decile of valuation. Extreme pessimism has always been the launching pad for robust returns over multiple market cycles.

The Mid-Cap Power Index is off to a good start following a good year in 2011. This index is constructed as follows: own the S&P MidCap 400 Index from November 1 to May 31, then own the Barclays Capital Intermediate Treasury Bond Index the remaining five months. Repeat every year.

The chart below shows the twelve-year history of this simple, mechanical asset allocation scheme (remember, this is an index, hence no fees or expenses are factored in).

In all likelihood, the next seven to ten years will play out much like the past twelve - plenty of volatility, a couple of recessions, and low total returns. This will continue until stocks get cheap again.

In the meantime, a simple seasonal strategy like the Mid-Cap Power Index should provide meaningful long-term returns, just as it has over the past twelve years. Since World War II, about 80% of market declines have been concentrated in the annual "dead zone", from early-May to late-October. The two big bear markets of the past twelve years were no exception.

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

Past performance is not a guarantee of future performance.

© 2012 Alpha Investment Management, Inc.
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