Alpha Power Investing Newsletter

September 11, 2012

Big and Really Big Pictures

As long-term readers know, Alpha does not manage money based on our analysis of current economic or market trends. In fact, we make a point of emphasizing how futile it is to try to correctly and consistently evaluate current events and their market effects. Instead, we adopt a "passive" approach - with a twist. We are passive investors in the stock market during pre-determined, repeating time periods.

During secular bear markets, our "passive tactical" discipline enjoys a huge advantage over traditional buy-and-hold disciplines. A "secular bear market" is an extended period of time spanning several market cycles (each of which lasts three to five years) during which bear markets of one to two years wipe out gains of the previous bull markets. Over this lengthy process, the market goes nowhere while corporate earnings keep increasing until, at some future point, the market is cheap and ready to enter a secular bull market.

In a "secular bull market", the market goes through cycles, but bear markets become "corrections" which are mild and leave most of the previous gains intact. The U.S. market from 1981-2000 was a "secular bull", whereas it has become a "secular bear" since early 2000.

Most investors are unaware of these big cycles and how they affect the multi-year returns of the stock market. Traditional investment advisors, who rely almost entirely on diversification to manage risk, promote this ignorance since their investment technique of holding stocks through thick and thin suffers disproportionately in a secular bear market. Investors persist in their suffering during these times because they believe that patience will eventually pay off with future returns rich enough to offset current losses.

As time goes on, however, and succeeding bear markets wipe out previous gains, patience ultimately gives way to capitulation - the towel is thrown in.

Capitulation by the investment public occurs at the end of the secular bear and marks the beginning of the next lengthy period of robust, above-average market gains. Naturally, at this time, the market is about as cheap as it's going to get. For the next decade or so, buy-and-hold becomes the dominant investment theme, luring the public back into the market arena over time.

So how close are we to the next secular bull market?

First, let's compare the current secular bear to a couple of examples. Doug Short (dshort.com) has produced two charts that begin to place things in perspective.

The first thing that jumps out at me when I look at these comparisons is that the current secular bear, even after 12 years, is still not mature compared to these examples. The next chart shows how returns after inflation are affected.

These examples are not as extreme as you might think. The last secular bear market, for example, lasted about 16 years, from 1965 to 1981 - in nominal terms. In real, inflation-adjusted terms, it took until 1990 to get back to the 1965 high (S&P 500 price only).

Secular bear markets, however, are not monolithic. That is, not all categories of stocks are affected equally or at the same rate. The market decline from 1968 to 1974 hit small-cap stocks especially hard - down 80% in real terms. As a result, small-cap stocks enjoyed a spectacular bull market from 1975 to 1981, while blue chips continued to go nowhere. It's quite possible that the same kind of "split" market is developing today, although I am not aware of it.

Over the past 100 years, however, there has been one unifying factor which precedes secular bull markets: stocks get dirt-cheap. Doug Short documents this effect in the chart below.

As you can see, at crucial long-term turning points, the ten-year PE ratio falls below 10, putting stocks in the first quintile of valuation. In early 2009, the ten-year PE ratio fell to the second quintile, but now stands in the fifth quintile. It's hard to imagine a long-term bull market starting with stocks at the highest quintile of valuation. The more likely scenario is that the current rally is an interim recovery in an ongoing secular bear market which will eventually culminate in dirt-cheap stocks in the first quintile. Based on the examples illustrated, this process could take another five to ten years.

Surviving and thriving in such a market requires a tactical discipline which takes you out of action periodically. Alpha's seasonal disciplines, which are completely passive and calendar-driven, have managed to negotiate the past 12 years quite successfully. This can be seen in the performance of the Alpha Seasonal Index, which ducks out of stocks at the same time every year and re-enters at the same time every year. To find out why this discipline has worked so well, read the brochure explaining the Alpha Mid-Cap Power Index Managed Account strategy which seeks to replicate the returns of the Alpha Seasonal Index net of fees and expenses.

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

Past performance is not a guarantee of future performance. The Alpha Seasonal Index is an index and, like the S&P 500 or any other index, is not investable. The performance of the Alpha Seasonal Index 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 Index 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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