Alpha Power Investing Newsletter

March 28, 2012

Getting to #1

Superior long-term investment performance in the stock market is a function of consistency. The principle ingredient of consistency is the avoidance of large losses.

Over the past twelve years the U.S. stock market has suffered through two bear markets. In both cases, losses in the neighborhood of 40%-60% were common to equity mutual funds and private portfolios.

Recovering from large losses is difficult for two reasons. First, the psychological toll is often so traumatic that investors sell out at precisely the wrong moment, then wait months or years before getting back in. By then, the market has recovered most, if not all, of its losses and the opportunity to "buy low" has passed forever. Next, the volatility of the market causes many investors to permanently shift to investments with guaranteed returns, which, of necessity, have lower long-term returns.

I have nothing against safety and guarantees. In fact, I think most investors take on too much risk and do not understand the worst case scenarios that face them. Nor do I have a problem with investment products, such as annuities, which offer "guarantees" of principal and/or income for life. The average investor would have done much better in these investments over the past 15 years than the normal experience in the stock market.

But, if you are going to have assets in the market and you are seeking robust long-term returns, then you must have a strategy for consistent returns, which means you must have a strategy for avoiding large losses because the stock market is inherently cyclical.

The key is understanding that some risks are unnecessary. By taking on these risks - which are hidden - investors are putting ticking time-bombs in their portfolios.

One of the main themes at Alpha is that stock market returns are not random. That is, the stock market does not distribute returns randomly over time. This theme has many variations, but for now let's take a look at non-random distributions over annual periods.

Yearly periods are subject to what I call the "annual forecasting cycle". This is the cycle that causes returns to be "skewed" over time into the six-to-seven month period beginning in late-October. During this period, small and mid-sized companies tend to outperform large, blue-chip companies.

Conversely, the period between May and November (which I call the "dead zone") is an investment toss-up. Since 1949, this period has been up just 55% of the time and has contained about 80% of all bear market declines.

To demonstrate this long-term effect, Alpha has created the Mid-Cap Power Index. The Mid-Cap Power Index is constructed like this: own the S&P MidCap 400 Index from November 1 through May 31, then own the Barclays Capital Intermediate Treasury Index from June 1 to October 31. Repeat every year.

The result of this simple experiment versus the Dow Industrials (held continuously) is illustrated below.

The difference is, as you can see, enormous and it is mostly due to consistency. This can be easily shown by looking at rolling three-year returns:

Alpha's Mid-Cap Power Index has had no negative rolling three-year returns. In other words, at the end of every quarter over the ten years, the Mid-Cap Power Index had positive three-year returns. Even at the bottom of the 2008-09 bear market, three-year returns were 2.7% per year and these returns snapped back to almost 10% annually in the next quarter.

The Dow, on the other hand, has experienced 15 negative rolling three-year periods over the same ten years. This is time lost to compounding - and compounding is the engine that drives long-term returns.

Last year there were 2,870 mutual funds that Lipper (the leading data gatherer in this industry) identified as growth funds. The chart below shows how the Mid-Cap Power Index fared over time against these funds.

Even though the Mid-Cap Power Index turned in a miserable fourth quarter performance in 2011 (-0.90%), it still outperformed 99% of growth funds for the year. The long-term rankings demonstrate just how important consistency is compared to the entire growth fund industry, which remains fully invested throughout market cycles.

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

Past performance is not a guarantee of future performance. The Mid-Cap Power Index is an index and, like the S&P 500 or any other index, is not investable. Investors may use funds which deviate from the indexes represented in the Mid-Cap Power Index. The data used to construct the Mid-Cap Power Index were obtained from a database provided by Callan Associates. While Alpha believes that the data is accurate, we cannot guarantee it to be so.

© 2012 Alpha Investment Management, Inc.
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