Alpha Power Investing Newsletter

July 30, 2012

Alpha Seasonal Index (Part II)

The S&P 500 stock index is just a simple recipe: the 500 largest stocks weighted by capitalization. That's it - and yet only one in five equity funds can beat it over any five-year period and just one in ten over any ten-year period.

The reason for this is fairly straightforward. Mutual funds are diversified and the greater the diversification, the closer the fund's portfolio comes to replicating the index. While fund managers may try to beat the index, the only way they can do it is by departing from the index - overweighting this or that sector, this or that stock, etc. The overall effect is minimal and is, usually, a drag on performance rather than an enhancement.

The proof of this is clearly demonstrated in the following graph, which depicts the performance of the average growth fund vs. the S&P 500.

As you can see, the average growth fund and the average large-cap growth fund have closely tracked the S&P 500. Also apparent is the fact that the superior performance of small-cap stocks (Russell 2000) has provided very little advantage to the average growth fund.

The bottom line for investors is that the vast majority of mutual funds are, in large part, just hidden index funds with higher fees. Yet investors keep falling for the same old pitch - that active management, in the form of superior stock selection, creates superior long-term returns. Alas, it just ain't so.

Alpha's investment philosophy is radically different. Our view is that superior long-term performance comes from managing market risk. Of course, the only way to do that is to be out of the stock market some of the time. Conventional wisdom regards this as a fool's game - market timing, as everyone knows, doesn't work. Instead, conventional wisdom advises investors to diversify widely and hang on.

The problem with this approach is that it can fail big-time under the right conditions. It failed, for example, from the mid-sixties to the early eighties, as both stocks and bonds went through extended secular bear markets.

Our approach begins with the observation that stock market returns are not distributed randomly over time. Instead, there are long-term statistical patterns which reveal that returns tend to be "skewed" into certain months of the year. One of these patterns is the skewing of returns into the six-to-seven month period beginning in late-October. Since 1950, the average daily appreciation of the Dow Industrials from November through April has been 27 times greater than the average daily appreciation during the other months of the year. This long-term statistical effect is the product of two phenomena: 1) The market is up just 55% of the time from May to November; and 2) about 80% of all bear market damage occurs in this time period (since 1950).

What's interesting about this effect is that it is not just local - it shows up globally in over 30 developed markets. Clearly, some substantial cause is at work. We call it the "annual forecasting cycle". It results from the demand for certainty that most investors seek. As a result, the investment industry puts forth an army of "experts" - professionals who, by dint of their superior knowledge, creativity, and dedication, are able to predict earnings, interest rates, trends, etc. These experts are highly literate, well-paid, sincere, and very confident in their forecasting ability. They are also, like us all, deeply flawed and most of the time their forecasts are wide of the mark. In general, they tend to be overly optimistic.

Late in the year, the experts make their forecast for the next calendar year. Their optimism normally raises investor expectations. This continues through the early part of the next year. The net effect is that investors are more tolerant of bad news during this period, tending to regard negatives as merely temporary.

As the year wears on, however, real information becomes available. By late-May, enough information is available to reveal the weaknesses of the experts' forecasts and this often results in downward revisions to earnings, reassessment of trends, etc. As this occurs, investors become less tolerant of bad news and the market becomes more vulnerable to panics.

Naturally, this doesn't happen every year, but it occurs enough over time to materially affect the distribution of returns over the long-term.

Recently, we contracted with Indxis (a division of Mergent, Inc.) to create and maintain the Alpha Seasonal IndexTM. This is an index which is constructed using a simple recipe. The formula comes in two parts. The first part specifies holding the S&P MidCap 400 Index from late-October to the end of May, then holding intermediate treasury bonds the remainder of the year. The second part specifies leveraging the S&P 400 by 50% for 20 days during three sub-periods in the fourth quarter of each year.

This formula is applied rigorously every year with no variation. The index is updated daily and made available through Thomson Reuters.

The chart below shows the performance of the Alpha Seasonal IndexTM compared to the S&P 500.

This period spans the two great bear markets we have experienced since the start of the millennium. Over this time period, the Alpha Seasonal IndexTM has yet to experience a down year. A fact sheet on the Alpha Seasonal IndexTM can be viewed at our website at www.alphaim.net or by clicking this link http://www.alphaim.net/seasonal_index.html.

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

Past performance is not a guarantee of future performance. The Alpha Seasonal IndexTM is an index and, like the S&P 500 or any other index, is not investable. The performance of the Alpha Seasonal IndexTM was computed by Indxis based on an algorithm provided by Alpha Investment Management. Indxis is a leading provider of index information to the financial services industry. The Alpha Seasonal IndexTM is the exclusive property of Alpha Investment Management, which has contracted with Indxis, Inc. to administer and calculate the index. Indxis shall have no liability for any errors or omissions in calculating the index.

 
© 2012 Alpha Investment Management, Inc.
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