Alpha Power Investing Newsletter

September 16, 2010

Washington D.C. Turns Friendly

We are now about to enter the election cycle "power zone". This period starts about 30 days prior to the mid-term elections and extends 15 months until the end of the pre-election year (2011).

Historically, this five-quarter period represents the most robust part of the four-year market cycle. Since 1913, the Dow Industrials have been down just once (1931) during this period (total return).

The following chart details the appreciation of the Dow during every power zone since 1933:

Over this period, the average gain during the five-quarter power zone has been 25.6%, representing an annualized return of 19.9% (with dividends). The average daily gain during the power zone was 7.65 times greater than the average daily gain during all other trading days. A $1,000 investment in the Dow grew to $66,120 during the power zone, even without interest earned in the intervening months. A $1,000 investment in the Dow during all other months grew to just $1,673 (as of December 31, 2009, appreciation only).

The cause of this remarkable phenomenon is the shift in political objectives in Washington, D.C. triggered by the mid-term elections. Following the mid-term elections, the political establishment turns its attention to the next presidential election. The party in power focuses on keeping the White House. The behavioral shift is dramatic. Incumbents pledge to balance the budget and reduce the deficit. Big spenders become fiscally conservative. All plans for tax hikes are shelved for the time being. Every incumbent knows that a thriving economy during the presidential election is a virtual guarantee that the status quo will be maintained. We can see it happening before our eyes, as Democrats are increasingly jumping off the Obama bandwagon and pushing for an extension of the Bush tax rates.

During the power zone, politics moves to the center, and investors respond with increased optimism for the future. This creates a positive market climate which shrugs off the inevitable negative economic/social developments of the pre-election period. As they say on Wall Street, "A bull market climbs a wall of worry."

The investor-friendly political environment during this period translates into real economic benefits.


Source: The Leuthold Group, as of December 31, 1919 - December 31, 2009.

The next nine months is especially robust because of the overlap of the annual forecasting cycle with the election cycle power zone. Long-term readers know that the behavior of market forecasters and stock analysts cause a boost in investor optimism from November through May. These gurus, who exert a strong influence on investors, are overly optimistic in their next-year projections for individual stocks and the market. This causes the market to be stronger from November through May than the rest of the year. Normally, by June, their optimism is waning and they are downgrading their earlier predictions. This causes the late-summer to be statistically "dead" over the long-term.

In the third year of the election cycle, however, their optimism is usually rewarded as the market tends to deliver strong returns throughout the year.

Research has established that aggressive strategies pay off during this part of the cycle. The Leuthold Group has studied market capitalization, style and sector performance related to the election cycle. Their conclusion is that growth stocks and cyclical stocks performed best during the power zone. Small-caps, growth stocks, technology, industrial commodities and precious metals have all tended to do best during this phase of the cycle.

Our programs (The FormulaTM and The E-System Portfolio) which exploit this pattern are equally divided between the S&P 500 and the NASDAQ 100 during the power zone. This is a large-cap, growth/technology portfolio.

The following chart shows the historical performance of the S&P 500 and the NASDAQ 100 over the previous five power zones. As you can see, even without interest earned in the interim periods, which comprise almost 70% of the overall time covered, investing during the power zone has been enormously profitable.

Inevitably, investors who know about this phenomenon are now questioning whether it will continue to deliver above-average returns. Does this quote from TIME magazine resonate with you?

"The US economy remains almost comatose. The slump already ranks as the longest period of sustained weakness since the Depression. The economy is staggering under many 'structural' burdens, as opposed to familiar 'cyclical' problems. The structural faults represent once-in-a-lifetime dislocations that will take years to work out. Among them: the job draught, the debt hangover, the banking collapse, the real estate depression, the health care cost explosion, and the runaway federal deficit."

Sounds dire, doesn't it?

Oh, by the way, it's from the September 1992 issue of TIME.

For a detailed study of the election cycle, go to the Alpha Research section of our website at www.alphaim.net, where you will find Mike Burk's comprehensive analysis of market history during past election cycles. For investment programs exploiting this phenomenon see the Programs and Performance section of our website, particularly The FormulaTM and the E-System Portfolio.

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


© 2010 Alpha Investment Management Inc.

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