Alpha Power Investing Newsletter

July 29, 2010

The 94% Fourth Quarter Bet

In my last newsletter, I wrote about why small-cap stocks, on average, do so well in the fourth quarter of the year. The cause, if you recall, was the annual forecasting cycle.

At year-end, earnings analysts and market forecasters are making projections for the next calendar year, which almost always turn out to be overly optimistic. Investors are listening to this army of highly-paid prognosticators and tend to bid up small-cap stocks, which are more leveraged and offer a higher return in good markets. This explains why the Russell 2000 Index has averaged a return in December of about 3%, roughly double the return of the S&P 500.

The behavior of small-cap stocks in November and December, especially at month-end and around holidays has been one of the most consistent profit opportunities of the past thirty years. There are three trading opportunities in the fourth quarter, at the turn of each month, totaling 20 days, when the returns of small caps tend to be very robust. I call them the fourth quarter "power periods". They are:

  1. The last 2 trading days of October and the first 2 trading days of November.
  2. The last 6 trading days of November and the first 3 trading days of December.
  3. The last 7 trading days of December (Santa Claus Rally).

Since the inception of the Russell 2000 Index in 1979, there have been 93 power periods, of which 83 were profitable - a 90% win rate overall. Looking at these periods on a quarterly basis reveals an even better track record: just two losing quarters out of 31 - a 93.5% win rate. The losing quarters were in 1984 (-1%) and 2006 (-0.60%). The average return has been 6.4% per quarter. This is a remarkable return for just 20 days a year of stock market risk exposure.

In Alpha's bond program - the ALPHA Bonds Strategy - we hold PIMCO funds all year long, then at the end of October we devote 60% of our portfolio to the power period trades. Because of the reliability of the Russell 2000 during these three periods, we leverage the trades by 50%, using special index funds designed for this purpose. The data showing all the power periods, the quarterly returns, and the returns with 50% leverage, are presented below:

As you can see, the average quarterly return over 31 years has been 9.7%. By committing 60% of our portfolio to these trades, we get almost full coverage of the power periods, while keeping 40% of the portfolio in the PIMCO Total Return Fund. The combination has produced a stunning fourth quarter strategy:

Fourth Quarter Returns
ALPHA Bonds Strategy Model

Net of Fees and Expenses

        1995: 10.5% 2000: 12.4% 2005:  5.5%        
        1996:   6.0% 2001:   7.2% 2006: -0.9%        
        1997:   6.5% 2002:   6.9% 2007:  2.4%        
        1998:   8.4% 2003:   6.1% 2008: 24.3%        
        1999:   9.4% 2004:   4.7% 2009:   1.8%        

The 15-year average return for the fourth quarter has been 7.4% net of fees and expenses.

Conservative investors should now be prepared for lower bond returns over the next decade. Rates are scraping bottom, and while this environment may persist, it is not one that allows bond managers to capitalize on bond price rallies caused by falling rates. In addition, the threat of inflation and its negative consequences for the bond market is somewhere out there in the future.

The ALPHA Bonds Strategy offers a low-risk equity "kicker" every year, which has paid off handsomely over more than three decades. This is a built-in growth engine which could offset the lower bond returns of the future.

For full-year results of this strategy, go to the Programs and Performance section of our website at Keep in mind that this program is available tax-deferred through the use of a flat-rate, no-load variable annuity for an additional $20 per month (not available to Ohio residents). Please contact me with questions.

Jerry Minton, Ph.D.

Past performance is not a guarantee of future performance. Please read important disclosures about model performance in the description of the program on our website.

© 2010 Alpha Investment Management Inc.

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