Alpha Power Investing Newsletter


May 12, 2011

On Schedule

At the beginning of 2000, there were a handful of skeptics predicting that stocks over the next decade would deliver low - perhaps even negative - returns. Robert Shiller of Yale, Jeremy Grantham at GMO, John Hussman of Hussman Funds, and Ed Easterling, founder of Crestmont Research, stood above the crowd and warned that stock market valuations were simply too high to reward long-term investors with the historically "average" return of around 10% annually.

These non-conformists stood in sharp contrast to popular opinion, including "expert" opinion, which was overwhelmingly bullish. At the end of 1999, investors had just been through the best five years of market returns since the depression. The S&P 500 yielded an annualized return of 28.6% during that period, more than doubling the value of the blue chips and growth companies composing the majority of the S&P 500 companies. Nobody was listening to the non-conformists.

These same voices are uniformly pessimistic today.

The source of their pessimism is valuation, i.e., how much investors are willing to pay for earnings. The price/earnings ratio can be computed in a variety of ways, but our non-conformists prefer the PE10, sometimes called the Shiller PE. This computation uses the ten-year average of past earnings adjusted for inflation instead of the normal one-year previous or one-year forecasted earnings. This method of computing valuation smoothes out the volatility that is normally associated with PE ratios of the stock market.

Valuations are, however, almost useless in assessing market risk over the short-term. Markets can stay overvalued for years, compared to historical norms. Generally speaking, predictions of future market returns for periods of less than five years using valuation measurements are so unreliable that they cannot be used as a serious risk-management tool. For periods of seven years and longer, their predictive power increases dramatically.

Based on today's Shiller PE of 23.6, the ten-year estimates for the S&P 500 range from 0% to 3.5% per year, depending on which guru you listen to. The Wall Street propaganda machine, on the other hand, is quoting the long-term market return of 10% per year as a way of reassuring twice-burned investors that things are, at last, back to normal.

I side with the pessimists when it comes to forecasting the ten-year returns of the market. At the same time, I know that multiple investment opportunities lie within this timeframe, just as they did between 2000 and 2010, in spite of two severe bear markets at both ends of the decade.

The proper course, it seems to me, is to use the low forecasted returns over the next decade as a tool for deciding long-term strategy. The clear message is that continuous investment in stocks over the next decade is unlikely to be rewarded. At some point in the future stocks will be cheap, just as they were in the early 1980's. At that time, long-term investors can take on the risk of continuous market exposure knowing that the market has always provided oversized returns for many years following such periods of general public pessimism.

So, the question for now is: What are the most reliable investment tactics to employ within an over-valued market?

Three of Alpha's programs employ a tactic based on the four-year presidential election cycle. As long-term readers know, the election cycle contains a 15-month period which historically has been very kind to investors. This period begins just before the mid-term elections and extends to the end of the pre-election year. I call this period the election cycle "power zone".

The election cycle power zone has not been down since 1931 (total return, Dow Industrials). Since then, the average daily appreciation of the Dow during the power zone has been about 7x greater than the rest of the time in the four-year cycle. In fact, were you to remove this five-quarter period from the history of the Dow, the remaining part of the index has appreciated about 1% a year since 1931.

The election cycle power zone is caused by the shift in politics that occurs after the mid-term elections. Politicians turn their attention to the next presidential election, knowing that the state of the economy will have a strong impact on voters. Therefore, political incumbents become more fiscally conservative, pro-growth, anti-tax, pro-business, and abandon (for a while) their big government proclivities. This encourages investors and the general market climate is elevated.

We are now about half-way through the current election cycle power zone. The first two quarters played out right on schedule. Our strategy during this period is to hold a portfolio evenly split between the S&P 500 and the NASDAQ 100. The result of this policy over the past five election cycles, plus the current cycle is charted below.

As you can see, an investor following this simple strategy, even without interest earned in the interim months (about 70% of the total time), would have just about doubled the cumulative return of the S&P 500 with just 31% of the risk.

To see the long-term effect of joining this strategy with our mid-cap power index strategy, go to the Home page of our website at www.alphaim.net and click on The FormulaTM.

The bottom line is that the current bull market probably has legs, in spite of being overvalued. I expect the market climate to remain positive well into the presidential election year.

If you would like to discuss 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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