Alpha Power Investing Newsletter

September 1, 2011

Fourth Quarter Power Periods

A remarkable investment phenomenon begins in late-October. Several Alpha programs are poised to exploit it.

In simple terms, late in the year the small-cap universe outperforms the blue-chip universe. For example, the Russell 2000 index, since its inception in 1979, has averaged a 3% return in December, compared to a 1.5% average return for the S&P 500.

This comparative over-performance of small-cap stocks has several causes. Chief among them is the "annual forecasting cycle". This cycle causes stock returns, in general, to be skewed into the November through April period. It's a long-term effect, but statistically undeniable. Since 1950, the average daily return of the Dow Industrials has been 27 times greater from November to May than the average daily returns for the other six months (appreciation only).

The principal cause of this skewing effect is the behavior of investors in response to the overly optimistic forecasts (for the next calendar year) of the army of highly paid, respected, and confident "experts" pronouncing on everything from company earnings to the stock market, GDP, interest rates, the price of oil, etc.

Most of the time these experts get it wrong and begin to revise their earlier estimates downward during the following summer, thus producing the May to November "dead zone", which, over time, is down 45% of the time and contains 80% of market losses (Dow Industrials since 1950). This effect is global, occurring in over 30 developed foreign markets.

One interesting consequence of this annual "skewing" is that investors migrate to riskier assets late in the year since, if the experts are right, these assets will deliver superior returns. This explains the over-performance of the small-cap and mid-cap indexes in November and December.

The most remarkable part of this effect is the performance of small/mid-cap stocks during three sub-periods of late-fall/early-winter. I call them "power periods" because they are so consistently profitable and robust. Altogether, they comprise just 8% of all the trading days of the year, 20 days in all. The chart below details the returns of these periods since the inception of the Russell 2000 small-cap index.

The Total Return column shows the quarterly returns of the power periods since 1979. Over 32 years, the average return was 6.4% annually, with just two losing quarters of 1% or less. That's a win rate of 94%, with no losses over any two-year period.

With this kind of investment efficiency, leveraging these trades by 50% makes sense to me, thereby generating the Total Return With 1.5 Beta column. As you can see in the summary, this has resulted in an average return of 9.8% per year. Obviously, this strategy leaves over 90% of the investment days each year open for other opportunities.

The chart below shows the 20-year return of the power period strategy vs. the S&P 500. As you can see, this strategy alone has handily outperformed the S&P 500 over this time period, 10.92% annually vs. 8.73%.

Several Alpha strategies exploit this phenomenon. The ALPHA Bonds program stays in bonds until late-October and then converts 60% of the investment into the power period trades at 1.5 beta. The Seasonal Strategy takes these trades each year in the fourth quarter, holding money market funds/cash between trades. The Mid-Cap Power Index Managed Account strategy holds the S&P MidCap 400 Index at 1.5 beta during the power periods, then steps down to the natural index between trades. The result for these programs has been enhanced fourth quarter returns; which, when combined with the investment strategy each pursues for the balance of the year, has produced smooth and robust annual gains for the past 15 years.

The outlook for both bonds and stocks for the next decade is grim. Stocks are currently priced in the top decile of historical valuations, based on the 10-year price/earnings ratio. No major bull market has ever begun from this high level of valuation. Bonds are now completing a 30-year bull market, with the 10-year Treasury bond recently hitting the 2% mark. Investors can no longer count on substantial interest rate declines to add value to bonds over the long-term.

Tactical strategies are the route to robust returns over the next decade. The exploitation of fourth quarter "power periods" within the small/mid-cap universe is a strategy which could add substantial, incremental returns to tactical bond and stock programs with minimal risk.

For more details about our tactical strategies, go to the Programs and Performance section of our website at www.alphaim.net and click on the corresponding links to read the brochures.

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.
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