Alpha Power Investing Newsletter

September 29, 2010

The Annual Power Zone

In about one month, the annual power zone comes into play. The annual power zone is the six month period from November 1 to the end of April. Since World War II, the stock market's positive returns have been "skewed" into this period, causing a distinct statistical "split" in the long-term returns. Since 1950, for example, $1 invested in the Dow Industrials from November 1 to April 30 has appreciated to $73.70. In contrast, $1 invested in the Dow Industrials from May 1 to October 31 has declined to 73¢ (as of December 31, 2009). The average daily gain from November to May was 27 times higher than the average daily gain of the other months of the year.

As our long-term readers know, this statistical effect occurs in 36 developed markets, many of which are more profoundly affected than the U.S. The effect is due to what I call the "annual forecasting cycle".

The annual forecasting cycle begins late in the year as the world-wide army of stock analysts, economists, and market forecasters make their predictions for the upcoming year. These forecasts tend to be wide of the mark, most often erring to the optimistic outlook. Investors, taking their cue from these "experts", are willing to take on more risk, thus supporting stocks late in the year and early on in the following year. As mid-summer approaches, and corporate earnings are beginning to emerge from the clouds, these analysts and market pundits regularly begin to downgrade their earlier estimates. This tends to put a damper on the market from May to November. Of course, this is a long-term statistical effect. The market is up about 50% of the time during the six month "dead zone", but most of the big down-drafts tend to occur during this period.

Investors can profit from this long-term phenomenon by avoiding the "dead zone" and owning stocks (in the form of index funds) only during the "power zone" each year. Our favorite index is the S&P MidCap 400 Index.

The S&P 400 was created in 1981 and represents 25% of the equity market. The index captures stocks with between one billion to five billion dollars of capitalization. Since its creation, the index has compounded at about 13.5% per year, a 35% annual return premium to the S&P 500 large cap index. The following chart shows how this differential affects long-term returns.

The mid cap index is also affected by the annual forecasting cycle, but extends its positive returns statistically through May. Therefore, the mid cap power zone is seven months long - November 1 through May 31. The next chart shows how the elimination of risk during the unfavorable five months (June 1 through October 31) has affected the index.

As you can see, the chart of the S&P 400 Power Zone is much less volatile than the index itself and has provided superior long-term returns.

Now, let's create the S&P 400 Power Index by adding in safe government bonds during the "dead zone". We use the Barclays Capital Intermediate Treasury Index as our bond component for five months each year.

The resulting index has had a total return of over 800% over the past 15 years, compared to a total return of 148% for the S&P 500. Since the S&P 500 outperforms most mutual funds, you can appreciate the magnitude of this performance differential.

For conservative investors, combining the S&P 400 Power Index with my favorite bond fund - the PIMCO Total Return Fund - has produced a remarkably consistent and very robust investment strategy. Two combinations, rebalanced annually, are presented below:

For retirees seeking a growth and income solution, the 50/50 combination is ideal. The annual volatility of this strategy is about the same as a 10-year treasury bill. This strategy has had just one losing year in the last 20 years (-5.5%, 1994), compounding at 10.5% over the past 10 years.

Do-it-yourselfers can easily construct this strategy using index funds. Our version of the 50/50 combination uses our ALPHA Bonds Strategy and our Mid-Cap Power Index Managed Account strategy. You can see the performance of these two strategies at the Programs and Performance section of our website at www.alphaim.net.

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

Disclosure: Past performance is not a guarantee of future performance. You cannot invest in indexes. Indexes have no fees and expenses. Index funds attempt to replicate the returns of the index, and most of them do so successfully with very low fees. None of the illustrations in this newsletter represent an Alpha program.

© 2010 Alpha Investment Management Inc.

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