Alpha Power Investing Newsletter

July 7, 2011

The Dead Zone

It's summertime and we are squarely in the stock market's "dead zone".

The dead zone for the S&P 500 large-cap index and the S&P MidCap 400 Index extends from June 1 to October 31. For the Russell 2000 small cap index, the dead zone is a month shorter - July 1 to October 31.

It is during the summer and early fall that earnings disappointments start to have an effect on private and institutional traders. Since 1950, the dead zone has been down about 45% of the time. Small cap stocks, being more volatile, tend to get hit the hardest, although this has not been true over the past decade.

Most years (excepting year three in the presidential election cycle) Alpha's equity programs avoid the dead zone, opting for intermediate bond funds instead. The chart below shows the 25-year history of intermediate government bonds during the five-month "dead zone" vs. the three major stock indexes.

Over this period, the dead zone has accounted for about 80% of the market's downside action. In fact, this phenomenon stretches back to the end of World War II and also shows up in over 30 developed markets globally.

The mechanism which causes this phenomenon is rooted in the fundamentals of human nature - I call it the "annual forecasting cycle".

Towards year-end, the vast army of professional forecasters - earnings analysts, economists, and other pundits - make their annual forecasts for the next calendar year. These forecasts are routinely wrong, normally tending toward rosy, overly optimistic outcomes. Remember, this army of professional "experts" is highly educated, confident, extremely well-paid, and most importantly, respected. Their optimism infects the investors and institutions that follow them, creating a positive market climate. As the calendar year unfolds, this optimism gives way to reality and rosy forecasts are downgraded to meet the emerging facts about earnings and profitability.

As I said before, the dead zone is up more often than down (about 55% of the time since 1950), but over the long-term, big market declines tend to concentrate in this period. Even over the great bull market decade of the 1990's, holding intermediate bonds during the dead zone proved to be a winning strategy.

Naturally, over the past decade, this strategy has paid off in spades - avoiding 90% of the bear market declines that have ravaged investment portfolios.

If you think about the "dead zone" as an investment in and of itself, there is no question that it is a long-term losing proposition. I have no doubt that over the next decade the dead zone will produce low-to-negative returns and will be outperformed by intermediate bonds.

If you examine the dead zone historically, you will find that in the pre-election year it is normally up. The only exception over the past 50 years was 1987, when institutional investors crowded into "portfolio insurance" trading schemes that backfired and caused the October crash. Since this is a pre-election year, the odds are high that the dead zone will be up. After this year, however, the probability of a large decline during the dead zone increases dramatically.

The "dead zone" phenomenon provides a simple mechanism for eliminating a substantial percentage of long-term market risk. A portfolio that replaces equity exposure with intermediate bond exposure during this period (especially in election cycle years one, two and four) will, over time, outperform a buy-and-hold portfolio with much less volatility. This advantage is doubly important in today's market, which is in the top decile of historical valuation and, therefore, subject to more frequent and deeper declines than normal.

Alpha's Mid-Cap Power Index Managed Account strategy avoids the dead zone every year, whereas The FormulaTM strategy continues 100% equity exposure throughout the pre-election year, then avoids the dead zone for election cycle years one, two and four. The details on these strategies can be found at the Programs and Performance section of our website at www.alphaim.net.

If you would like to discuss any of our investment programs, please call me at 1-877-229-9400.

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

Past performance is not a guarantee of future performance.

 
© 2011 Alpha Investment Management, Inc.
Alpha Power Investing Newsletter Archives