Alpha Power Investing Newsletter

June 2, 2010

Non-Random Returns

In our last newsletter, I took a swipe at the Efficient Market Theory. If you remember, this theory states that the market is priced efficiently, meaning that all useful information is already incorporated in stock prices. In addition, new information is rapidly digested by millions of investors and incorporated into prices in short order. Therefore, it is virtually impossible to "beat the market" since information drives prices and no one can consistently outwit the millions of minds which are constantly processing new information.

The upshot of this theory is that the market is "random" and "unpredictable". At the same time, however, the theory assumes that stock prices will rise over the long-term, reflecting the growth of corporate earnings in a more or less free-market economy.

My response was that this viewpoint misses the point. By focusing on information processing the theory misses the true driver of stock prices - human nature. Understanding human nature opens the door to market "predictability".

Our view is that the market is profoundly affected by cyclical forces which alter investor sentiment in predictable ways. In particular, these cycles cause a "skewing" of market returns into time periods which I call "power zones". A power zone is a cyclical time period when investor confidence is on the rise, causing a positive investment "climate". During these periods, investors view events through rose-colored glasses and tend to ignore developments which are "bad". Thus the expression, "A bull market climbs a wall of worry."

One of these cyclical forces is the four-year presidential election cycle. As I pointed out in the last newsletter, the third year of the presidential term - the pre-election year - hasn't been down since 1931 (total return, Dow Industrials). The average appreciation of the market in the third year is 17.5%, more than three times the average of the other three years. Moreover, the fourth quarter of the president's second year - the quarter containing the mid-term elections - is exceptionally powerful, averaging a 7.5% appreciation. Combine these two periods and you get a 15-month "power zone" which hasn't been down since 1931, averaging a 25% appreciation plus dividends.

This is about as non-random as you can get.

The mid-term elections trigger a change in political ambitions in Washington, D.C. Politicians and their allies now focus on the next presidential election and they begin to woo the electorate with promises of fiscal responsibility, balanced budgets, lower taxes, less legislative activism, and government reform. When possible, the Fed joins in to keep interest rates low and/or stable and provides plenty of liquidity to the banking system. The entire political establishment is aiming for the same thing - a good economy at election time.

This shift raises investor confidence and produces the statistical "skewing" of returns into the 15-month "power zone". Typically, this optimism spills over into the election year, as well.

In the last newsletter I pointed out that investment strategies which take advantage of the predictability in human nature can prosper during long periods of investment malaise. The past ten years certainly qualifies, as does the almost 20-year period from the mid-sixties to the mid-eighties, when the Dow stalled out at 1000 multiple times, before finally taking off in 1983.

The table below shows the total return of the S&P 500 during the election cycle power zones from 1954 until now.

S&P 500, with dividends reinvested
1954 - 2008
1954 Q4: 11.4% 1970 Q4: 9.4% 1986 Q4: 5.6% 2002 Q4: 8.4%
1955 All: 26.4%

1971 All: 10.8%

1987 All: 5.2%

2003 All: 28.7%

TOTAL: 40.8% TOTAL: 21.2% TOTAL: 11.1% TOTAL: 39.5%
1958 Q4: 10.3% 1974 Q4: 9.4% 1990 Q4: 9.0% 2006 Q4: 6.7%
1959 All: 8.5%

1975 All: 37.2%

1991 All: 30.5%

2007 All: 5.5%

TOTAL: 19.7% TOTAL: 50.1% TOTAL: 42.2% TOTAL: 12.6%
1962 Q4: 12.1% 1978 Q4: -4.9% 1994 Q4: 0.0%
1963 All: 18.9%

1979 All: 18.6%

1995 All: 37.6%

TOTAL: 33.3% TOTAL: 12.8% TOTAL: 37.6%    
1966 Q4: 4.9% 1982 Q4: 18.2% 1998 Q4: 21.3%    
1967 All: 20.1%

1983 All: 22.6%

1999 All: 21.0%

TOTAL: 26.0% TOTAL: 44.9% TOTAL: 46.8%    

$1,000,000 Invested grows to $42,192,000
Total Time Invested: 17.5 Yrs
Compound Annual Return: 24%
Down Years: 0

As you can see, during the secular bear market of 1965-1983 which was characterized by rising and high inflation, rising interest rates, Vietnam, student unrest, the counter-culture, Nixon, and other various and sundry problems, the S&P 500 delivered consistently high returns during election cycle power zones. The NASDAQ index did even better. An investor who held stocks only during these periods and intermediate treasuries the rest of the time would have breezed through one of the most difficult investment climates in history with almost continuous gains.

The same is true of the past decade, which has turned out to be one of the worst ten-year periods of the last 100 years.

Two of Alpha's programs depend heavily on this powerful cyclical force - The FormulaTM and the E-System Portfolio. Both programs are now in bonds waiting for early October and the arrival of the next election cycle power zone.

Jerry Minton, Ph.D.

© 2010 Alpha Investment Management Inc.

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