Alpha Power Investing Newsletter

May 4, 2010

Sell in May

The sidelines beckon.

Three Alpha programs are moving from equities to bonds in May. By month-end, all programs will be in bonds.

This is the second year of the four-year presidential election cycle and it can be extremely volatile. The second year has often been the final year of big bear markets (1974, 1978, 1982, 2002) and of significant market corrections (1990, 1994, 1998, 2002, 2006). Historically, the worst quarter of the four-year cycle has been the third quarter of year two, while the fourth quarter of year two has been the best of the cycle.

If you think about the market in terms of two overlapping influences, each exerting a powerful force on investor psychology, the cause for this historical affect becomes clear.

The first force is the annual forecasting cycle. This force causes positive returns to be "skewed" into the six to seven month period from late-October to early-May. The Dow Industrials (since 1949) have had an average daily return during this six-month period which is 27.5 times greater than the average daily return of the other six months. This cycle is caused by the army of stock analysts issuing overly optimistic earnings projections in November - December for the next calendar year. Then in mid-year the "experts" tend to revise these estimates downward in response to the emerging reality of corporate earnings. This force causes the "sell in May" slogan to be true about half the time - since the market is down about 45% of the time from May to November (since 1949). I have dubbed this period the "dead zone".

The second force at work is the election cycle. The approach of mid-term elections and the resulting uncertainty of the outcome combines with the "dead zone" to produce a toxic atmosphere for stocks. Worried investors are busily shifting their assets around, putting downward pressure on the market. Normally the worst is over by early October.

By then, investors have figured out how the elections will go, and the uncertainty begins to lift. In addition, the dominant party is sure to lose seats, resulting in a more centrist government for the last two years of the cycle. The political rhetoric begins to change as Washington D.C. gears up for the next presidential election. Politicians, as a class, adopt a mantra of fiscal responsibility - vowing to reduce the deficit, balance the budget, and pare spending to the bone.

Time after time, the investment class buys into it. The third year of the cycle hasn't been down since 1931, with the Dow averaging over 17% appreciation plus dividends during this period of political theatre.

So the chances of making money in the market this year between June and November are slim. Besides, regardless of the year in the election cycle, the "dead zone" is up just half the time historically and contains about 75% of all market damage since WWII. It's a losing long-term proposition, so why play?

On the other hand, the fourth quarter of year two is especially productive historically because of the overlap of the election cycle "power zone" and the beginning of the annual forecasting cycle. It's a one-two combination that has produced consistently high returns since the 1930's.

For Alpha clients, the best scenario this year would be a steep, dramatic market correction before October, which would set up the fourth quarter as a typical post-election recovery leading into a robust typical third year of the election cycle.

To find out more about the election cycle and its affect on the market, go to our website at www.alphaim.net and click on the Alpha Research tab at the top of the Homepage. Mike Burk, Director of Research for Alpha, has prepared an interesting study chocked full of data for investment geeks. You can also click on Recent Articles and find my article on the election cycle.

Sincerely,
Jerry Minton, Ph.D.
President



© 2010 Alpha Investment Management Inc.

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