Alpha Power Investing Newsletter

August 21, 2013

Late in the Game

We are about to close out the fourteenth year of stock market returns since the end of the most speculative period in U.S. securities history. The market peaked in early 2000, reaching levels of valuation more extreme than any previous era, including 1929. Since then, the inflation-adjusted total return of large cap, blue chip stocks has been virtually zero, as shown in the chart below:

One would suppose that after such a long dry spell (in real terms) stocks would be ready for a major bull market again. Alas, it isn't meant to be. In fact, a major bear market is most certainly in the cards. You can see the reason for my pessimism in the chart below:

This chart shows the long-term, historical value of the Shiller PE. The Shiller PE is the price/earnings ratio of the S&P 500 averaged over 10 years, discounted for inflation. It is one of the best measures of valuation available, particularly for long-term investors because it de-emphasizes the recent past.

Every major bull market (as opposed to a 3 to 5 year upswing) has been preceded by truly cheap stocks. By "truly cheap", I mean Shiller PE's in the 5-10 range. Today the Shiller PE is 23.6, in the top decile for readings for the past 120 years. As you can see, today's level of valuation roughly corresponds to past periods of low to negative stock returns (1905-1920, 1929-1942, 1967-1982). For investors this means a continuation of bull to bear phases, with little long-term appreciation. It also means that the current bullish phase, which started in 2009, will be paired with a bearish completion of the cycle. When this occurs is anybody's guess, but most likely it will happen within the usual 4 to 5 year bottom-to-bottom cycle which has prevailed over the past fifty years.

If the future is anything like the past, our Alpha Mid-Cap Power Index Managed Account strategy should survive the upcoming decline by staying on the sidelines during the worst months. The chart below shows the history of the Alpha mid-cap discipline for the past 13 years using inflation-adjusted returns compared to the S&P MidCap 400 Index and the S&P 500

This record reflects a 15% participation in the bear markets of the period and an 82% participation in the bull markets.

Given that a bear market is in the cards, why believe that a simple seasonal discipline can avoid the worst of it? Our mid-cap program avoids stocks from June 1 to late-October, then invests in the S&P MidCap 400 Index the remaining months. The built-in assumption is that during a bear market, there will be periods of strength offset by more prevalent periods of weakness. Our presumption is that we can minimize losses by avoiding the market during the months that have historically been most adversely affected by market weakness. We know that the full cycle is a reflection of human nature and that earnings disappointment is most likely to surface after May, when full-year results begin to clarify for investors. We also presume that once investors recognize their mistakes, they will clamor for the exits en masse, causing the most damage from June to November.

This behavioral pattern is not written in stone, for there have been instances of severe market damage during other periods during the year. It is, however, the historical norm, and for long-term investors the discipline of avoiding stocks from May to November has paid off in spades, particularly with mid-cap and small-cap stocks.

For a complete description of the Alpha Mid-Cap Power Index Managed Account strategy, go to our website at www.alphaim.net and click on Programs and Performance.

Sincerely yours,

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

Disclosure: Past performance is not a guarantee of future performance.

 
© 2013 Alpha Investment Management, Inc.
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