Alpha Power Investing Newsletter


April 14, 2011

Lower Risk, Higher Returns

Most investors are familiar with the arithmetic of losses: the deeper the loss, the higher the return required to recoup it. A 50% loss, for example, requires a 100% gain to recoup. Stated another way, a 50% loss wipes out previous gains of 100%.

This simple fact is why risk management is essential to a successful long-term investment; particularly an investment in the stock market which can experience periods of wild volatility. Deep losses, especially when viewed in inflation-adjusted or "real" terms, have historically required long time periods to recoup. On the other hand, deep losses are opportunities for investors with cash and with a discipline to exploit them.

As regular readers of this newsletter know, the stock market delivers high returns over time during the six-month period from November to May. As you may also remember, this is a global phenomenon, occurring in over 30 developed markets. To put it into quantitative terms, since 1950 the Dow Industrials, between November and May, have appreciated at an average daily rate that is 27.4x greater than the average daily appreciation during the other six months. This favorable six-month period, which I call the "annual power zone", is caused by recurring end-of-the-year optimism concerning the next calendar year expressed by the "forecasting industry", i.e., pundits, earning analysts, economists, and other market experts. The lower returns which occur between May and November are caused by the downward revisions of their long-term forecasts in the face of actual earnings which are emerging at mid-year. Of course, this doesn't happen all the time. The market is up about 50% of the time between May and November, often spectacularly. But, over time, about 80% of market declines occur during this period, and some of them are very deep.

In light of this phenomenon, let's create the "Alpha Dow". The Alpha Dow is the Dow Jones Industrial Average with dividends reinvested held for six months from November to May, then reinvested in the Barclays Capital Intermediate Treasury Index for the other six months. The chart below shows the effect of this strategy from the start of the bear market of 2000-02 until the end of 2010.

As you can see, the Dow Industrials from November through April slightly outperformed the Dow held continuously with dividends reinvested. Please note that it is much less volatile than the Dow. You can also see that intermediate treasuries have significantly outperformed both. When we combine the intermediate treasury returns from May to November with the Dow Industrials' return from November to May, we get the Alpha Dow chart. Over this highly volatile 11-year period, the Alpha Dow returned 6.4% annually vs. 2.4% for the Dow Industrials. In other words, this risk reduction strategy tripled the returns of the Dow. For a $1,000,000 investment, this represents a $700,000 bonus over the market return.

Now let's ask the all-important question: How much did we reduce market risk by using this strategy? This question can be easily answered by looking at the "down market capture ratio" which calculates how much of all the declines in the Dow are "captured" by our strategy, the Alpha Dow. As it turns out, over the past 10 years, the Alpha Dow captured 31.1% of the Dow's declines, and over the past 15 years captured just 19.6% of the market's declines. I believe it is fair to say that this represents a 70% to 80% reduction in risk.

But what about strong bull markets? Doesn't this strategy reduce your returns when stocks are booming?

To answer this question, let's look at a chart for the last 16 years which contains the years 1995-1999, the strongest five-year period for the Dow Industrials since World War II.

During the five years beginning with 1995, our risk reduction strategy kept pace with the Dow. Once again, the reason is that most of the gains during this period were skewed into the November through April power zone and intermediate treasuries were also in a bull market.

While the Alpha Dow certainly reduces market risk and raises returns over time, it is not the most efficient way to exploit the annual power zone. My research shows that the S&P MidCap 400 Index is the most effective stock index to exploit this long-term phenomenon.

There are several reasons why. First, smaller capitalization companies routinely outperform blue-chip companies during bull markets. Since our simple strategy consistently zeros in on the most productive time periods of bull markets, the additional risk is a fair trade-off for higher returns. Second, Standard & Poor's imposes a profitability requirement on the index, thereby eliminating struggling companies and larger companies that may fall into the mid-cap space due to earnings problems. Third, small companies experiencing strong earnings growth move up the capitalization ladder as their stock price rises and qualify for the index as long as they are not "large cap". In effect, this requirement bars problem companies like Enron, while admitting rising stars like Netflix.

The Alpha Mid-Cap Power Index is constructed much like the Alpha Dow with the addition of May as an extra month of equity exposure. The Barclays Capital Intermediate Treasury Index is held for five months instead of six.

By using the S&P MidCap 400 as the equity vehicle, our 11-year rate of return jumps to 13.8% and the 16-year return to 16.5%. For a $1,000,000 investment, this is a $2,900,000 return bonus over the Dow Industrials over the past 11 years.

Just how good is this compared to mutual fund performance?

The Mid-Cap Power Index ranked in the top 1% of performance for all time periods greater than two years compared to all growth funds since 1999.

In our Alpha Mid-Cap Power Index Managed Account, we seek to duplicate the returns of the index net of fees and expenses. We do this by using several enhancements which seek to add returns to the basic strategy over time. For example, actual managed accounts use the PIMCO Total Return Fund instead of the Intermediate Treasury Index as the fixed-income component of the strategy. This intermediate bond fund, managed by Bill Gross, Morningstar's Fixed Income Manager of the Decade, has consistently outperformed the treasury index.

To find more information about this strategy, 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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