Alpha Power Investing Newsletter


March 31, 2011

False Promises

Every investment advisor who recommends long-term continuous exposure to the U.S. stock market makes the assumption that over the recommended holding period, whether it be seven years or twenty years, the stock market will deliver returns worth waiting for.

In virtually all promotional material, these advisors, brokers, mutual fund sponsors or money managers, make the claim that the U.S. stock market has delivered a long-term return of about 10% per year. The implication is that the patient investor who is "long-term" can reasonably expect to harvest similar returns. The price to be paid for this superior return is the pain of going through periodic and infrequent market declines. Investors are reassured, however, that these declines are temporary and will not result in a permanent loss of capital.

I regard this pitch as unscrupulous and unethical, or as resulting from a dismaying ignorance of the stock market and the way it distributes returns over time.

Take a look at the past 11 years, for example. Let's examine it from the point of view of purchasing power, not dollars. If we adjust the returns of the S&P 500, the average growth fund, and the average blue-chip large-cap growth fund for inflation, what we get is something that I would call the permanent loss of capital.

An investor nearing retirement or just retiring 11 years ago who followed the conventional wisdom, placing most of his/her assets in the most popular mutual funds, would now be in a deep financial hole.

The 30% loss of purchasing power in the S&P 500 (which outperforms 80% of large-cap funds over the typical ten-year period) requires a 45% increase in purchasing power (not dollars) just to return to even. A 1999 retiree (at age 65) will most likely have to live to be 120 to see a 10% nominal return on his starting investment.

This is not unusual.

Let's say you retired in 1966 and invested in the S&P 500 and you used the dividends for income. The purchasing power of your investment dropped by 50% over the next ten years, and didn't return to its original value until 1992. You can see this for yourself at the website for Robert J. Shiller, Professor of Economics at Yale University (www.econ.yale.edu/~shiller/ - click the link Information for Irrational Exuberance).

What concerns me now is that the U.S. stock market may be in a Japan-like phase which could last far longer than anyone dares to imagine. If you recall, in the late 1980's Japan Inc. was believed to be the greatest economy in the world and its economic growth unstoppable. Simultaneously, the Japanese real estate market was in a bubble as was its stock market. Twenty years later, the buy and hold Japanese stock market investor, even with dividends reinvested, has gone nowhere.

In order for the buy and hold approach to work, stocks need to be moving from cheap to expensive, such as occurred from 1982 to 2000. The best long-term indicator of "value" is the ten-year cyclically adjusted price-to-earnings ratio. Robert Shiller has reconstructed this indicator going back 130 years and, based on his research, the U.S. stock market is very expensive today, selling at 24x cyclically adjusted earnings. Every bull market in the past 130 years has begun with this ratio below 10. This means, in effect, that more volatility and long-term sideways price movement is in the cards. It is essential, in such market environments, that investors confine their market exposure to limited time periods when downside risk is minimal.

The Mid-Cap Power Index demonstrates how this works over time. The index is out of the market from the end of May to the end of October - invested in intermediate treasury bonds during this period every year. This five-month period, which I call the "dead zone," historically has contained about 80% of all bear market downside risk since 1949. Conversely, the S&P MidCap 400 Index, since its inception 30 years ago, has produced consistently positive returns between late-October and late-May, with only four losing periods: 1981 (-2.3%); 1983 (-9.3%); 1993 (-1.8%); 2007 (-2.0%).

To find out why, go to the Programs and Performance section of our website at www.alphaim.net and click on the Alpha Mid-Cap Power Index Managed Account link to read the brochure.

If you would like to discuss this or any of our investment programs, 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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