Alpha Power Investing Newsletter

May 7, 2012

International Diversification

Since the end of 1999, the U.S. stock market has experienced two bear markets: March 2000 to August 2002 and October 2007 to March 2009. Both bear markets were deeper than 40% top-to-bottom (S&P 500 price only), with some mutual funds experiencing 60% to 80% declines in both cases.

Many investment advisors have promoted diversifying portfolios into foreign equities in order to dampen U.S. volatility and increase returns. The chart below demonstrates the near-futility of that approach over the past 12 ¼ years.

With the exception of Emerging Markets, foreign exposure has been mostly an exercise in futility as both European and Asian markets pretty much marched in lock-step with the U.S. As you can see, however, Emerging Markets exposes investors to much higher volatility and much deeper losses in bear markets. In 2008, for example, Emerging Markets dropped 70% and have yet to recover.

As readers of this newsletter know, Alpha's solution to risk management is to hold equities only during time periods when repeating seasonal influences exert a positive force on the market. One of the most reliable seasonal forces is the annual forecasting cycle, which tends to provide a consistent positive influence on the market from late-October to late-May. Over the past 62 years, the market has been up 80% of the time during this period.

As long-term readers also know, this influence is not confined to the U.S. Since the forecasting cycle is an artifact of human nature (which is the same everywhere) it is reasonable to assume that it displays its effects in most foreign markets. Research has shown that it clearly influences the long-term results of about 30 foreign markets, skewing returns into the annual "power zone".

In our market, this is clearly illustrated in the Mid-Cap Power Index, which is constructed by holding the S&P MidCap 400 Index from November through May, then holding the Barclays Capital Intermediate Treasury Index the other five months of the year. The chart below shows the effect of this policy against the U.S. and foreign indexes across the two bear markets of the past 12 ¼ years.

If any reader is currently holding an Emerging Markets mutual fund or thinking about investing in one, take a look at what happens over the long-term by holding the MSCI Emerging Markets index from November through May, then holding intermediate treasury bonds the other five months of the year (Seasonal Emerging).

As you can see, over the past 12 ¼ years, the seasonal approach has more than doubled the returns of the MSCI Emerging Markets index while eliminating most of the hair-raising declines in 2000-2002 and 2008-2009.

Another thing clearly demonstrated by these charts is that international diversification has been powerless to mitigate risk over the past decade. This is not to say that such an approach must always fail. It will succeed if the foreign market is clearly undervalued in relation to the U.S. This was the case in the mid-sixties, when Japanese stocks were dirt cheap compared to the U.S. Today, however, there are few pockets of deep value internationally and so it is reasonable to expect that the volatility of the U.S. market will be mirrored in most other countries as well. As a result, all investors should keep market risk under control by exploiting the annual "power zone".

The Alpha Seasonal Strategy has just exited the market and will hold bonds until the end of September. The FormulaTM and Mid-Cap Power Index Managed Account strategies will exit the market at the end of May, returning to equities in late-October.

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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