Alpha Power Investing Newsletter

August 17, 2010

What Bear Market?

When the average investor thinks about the stock market, he/she tends to think in terms of yearly returns. This is a big mistake.

By thinking of stock market returns on a calendar-year basis, one is forced into thinking of investing as a process of holding stocks continuously. Once your thinking is conditioned this way, you define stock market opportunity and stock market risk in these terms. Looking at the returns over the past ten years within this framework, one would have to conclude that stock market risk has been high and returns have been low. The S&P 500 has returned 0% over the past ten years and suffered two 50% declines. The 1990's, on the other hand, look positively glorious, returning 18.2% per year with a handful of minor setbacks.

Thinking of the stock market in terms of "market climate" can change these perceptions dramatically. By "market climate", I mean the time zones within each year when stocks tend to be perceived with a positive bias. I call these periods "power zones". An investor who perceives the market in terms of annual "power zones" can barely tell the difference between the past ten years and the previous ten years. Both decades have been immensely profitable.

The annual power zone stretches from November 1 to the end of April or May, depending on the category of stocks being considered. For mid-cap stocks, which deliver higher long-term returns than large-cap stocks, the power zone is seven months long - November through May.

Over time, stock market returns are "skewed", with positive returns occurring much more frequently in the power zone than in the remaining months, which I call the "dead zone". Long-term readers know that the cause of this effect is the "annual forecasting cycle". Late in the year, the highly-paid, respectable army of "forecasters" go through an annual ritual. Stock analysts, economists, and other "experts" make their predictions for the next calendar year. These forecasts almost always turn out to be optimistic - wildly so, in many cases. Investors respond to these predictions with optimism, making November and December two of the best months of the year statistically. Small and mid-cap stocks do especially well during this period, with the mid-cap index outperforming the S&P 500 by two to one in December. The investment climate remains positive until mid-year, when reality forces the "experts" to pull in their horns. This puts a statistical "drag" on the market in late-summer and early-autumn. Since World War II, 75% of all market damage from bear markets has occurred during the "dead zone", resulting in an overall 60-year loss of about 20% during this period.

If we restrict our thinking to the positive annual market climate (power zone) affecting the S&P MidCap 400 Index, then we come up with the Mid-Cap Power Index, i.e., the S&P MidCap 400 Index held from November 1 through May 31, and the Barclays Capital Intermediate Treasury Index held from June 1 through October 31. The result is presented below:

This index has had no down years over the past decade, with a compound annual return of about 13%. During the previous decade, it had one down year (1994, -6.5%) with an annual return of about 19%. The "power zone" average return during the 1990's was 14.3% per year compared to 9.7% annually during the past decade.

The worst volatility in the index occurred in 2008-09, but not enough to produce annual losses. The index gained 1.7% in 2008, compared to a loss of 37% for the S&P 500. In 2009, the index was up 21%, and so far this year (thru June 30) is up 7.1%.

While this form of thinking about the stock market is foreign, you can see that it makes much more sense than conventional thinking which is always cast in terms of yearly returns.

Systematic, disciplined investors who follow this "market climate" approach over the long-term, have been amply rewarded for their unconventional (and less risky) investment method. Alpha's Mid-Cap Power Index Managed Account offers unconventional thinkers an easy way to capitalize on one of the simplest and most robust investment strategies ever discovered. For details, go to the Programs and Performance section of our website. Remember, this strategy is available tax-deferred for taxable accounts. Please call me for details.

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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