Alpha Power Investing Newsletter

June 13, 2013

Alligators

The stock market is intrinsically cyclical - always has been, always will be. Being a human arena, it is subject to the laws of mass psychology. When it comes to experiencing risk, human psychology is perverse.

A happy investment public creates unrewarded risk in the form of overvalued markets, whereas a terrified investment public creates substantial rewards for risk in the form of higher future returns due to undervaluation. The longer the market advances without a substantial decline, the more the investment public discounts risk and overpays for securities. The resulting cycles can take many forms. Some cycles are multi-month, others are multi-year, and some can take up to two decades to complete.

We are currently 13 years into a bearish long-cycle, which began at the end of 1999. The origin of this cycle was the extreme overvaluation of stocks at the end of the 90's. The Shiller PE ratio (price divided by the ten-year average of inflation-adjusted earnings) for the S&P 500 was over 40 at the start of the new millennium. This degree of overvaluation was unprecedented in the history of the U.S. market. The last time stocks got to major overvaluation was in the mid-60's, when the Shiller PE reached a high of 24. This heralded the beginning of a 17-year bear cycle which ended in 1982 with a Shiller PE of 5 - the result of the market going nowhere while corporate earnings increased.

The Shiller PE is now 23.7.

While the current long-cycle has been unfriendly to stocks, it has been very friendly to bond investors. The chart below shows the inflation-adjusted returns of the S&P 500, intermediate treasury bonds, and high-yield bonds (junk bonds).

As you can see, bond investors made it through this phase of the long-cycle with real gains, while stock investors are just beginning to recoup their long-term losses.

Right now the bad news is that we are in a happy market. The last bear market bottom was in March of 2009. Both the Dow Industrials and S&P 500 have recently moved to new all-time highs (just barely). The talking heads are pronouncing that we are in a new bull market. Margin investors (buying stock on credit) have more debt today than at the peak of 2007. Risk-averse retirees, thirsting for yield, are wading into the river in droves, impervious to the alligators.

I draw two conclusions from this situation:

  1. The long-cycle is not even close to completion. With a Shiller PE of 24, equal to the overvalued market of the mid-60's, and far from the undervalued markets that have historically preceded long bull cycles (Shiller PE's under 10), investors are going to suffer through more volatile, trendless, and frustrating markets. This will persist until stocks are cheap once more (and the investment public is terrified).
  2. The current four-year advance is long in the tooth, displaying the same signs of risk as preceded the 2008-09 downturn. The smell of a bear market is in the air - how severe or when, who knows?

Seasonal investors have an easy tool for negotiating the tough times ahead - a tool that converts volatility into a positive force over time.

The chart below shows the performance of a simple strategy - the Seasonal Mid-Cap strategy - for the past 13 years. Here's the strategy:

  1. Hold the S&P MidCap 400 Index from November through May.
  2. Hold the Intermediate Treasury Index the other five months.

This strategy exploits the fact that the vast majority of bear market damage has historically affected the market from June to November. To find out why this occurs, read our Mid-Cap Power Index Managed Account brochure which can be found at our website (www.alphaim.net).

If I'm right about our position in the long-cycle, investors will not prosper by conventional thinking. It may turn out that both stocks and bonds will suffer over the next decade, just as occurred from 1965-1982. Long term success in this type of environment requires investors to periodically adjust their exposure to market risk. A seasonal discipline, based on constants in human mass psychology, offers a unique approach which has delivered robust returns through thick and thin over the past five decades, and most notably, over the past 13 years of the bearish long-cycle we are still experiencing.

Sincerely yours,

Jerry Minton, Ph.D.
President
1-877-229-9400, Ext. 11

Disclosure: The Alpha Mid-Cap Power Index Managed Account program is not the same as the Seasonal Mid-Cap illustrated. The illustration is a strategy that has no expenses factored in. The Alpha Mid-Cap Power Index Managed Account employs additional and different factors than the illustration. Past performance is not a guarantee of future performance. For a complete disclosure please see our brochure at the Programs and Performance section of our website at www.alphaim.net

 
© 2013 Alpha Investment Management, Inc.
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