Thursday, March 8, 2012

Alpha's Mid-Cap Power Index Strategy

One of the messages I keep repeating over and over in these newsletters is that investors have a risk-reducing, return-enhancing investment strategy always available to them. This strategy is easy to understand, empirically verified, easy to implement, and completely transparent. Even better, as long as you have an investment horizon of three to five years or more, it really hasn't mattered when you begin to use this strategy - every three to five year period over the past 30 years has provided generous returns with superior risk management over multiple economic scenarios.

The strategy I'm referring to is this: each year invest in the S&P MidCap 400 Index from November 1 to May 31, then hold intermediate bonds for the other five months of the year. The table below details the annual results of this strategy vs. the S&P 500 over the past 30 years.

This strategy has had just one losing year since 1981 (-6.7% in 1994) and has enjoyed robust returns through the last 12 years which have contained two severe bear markets. Only now is the stock market beginning to lift above its late-1999 level (with dividends reinvested), whereas this simple strategy is up about 360% over the same period.

The following table details the three-year returns of the strategy over the past 15 years. What it shows is that the index delivered positive returns over both bear markets (2000-2002, 2007-2009) with quick recoveries.

For investors with a five-year horizon, the results are even better. Looking at these rolling five-year returns, it's hard to see anything resembling the effects of two of the worst bear markets of the past half-century.

This simple, mechanical strategy is destined to remain obscure and generally neglected. It violates one of the most basic presumptions of the typical investor; namely, that the year-to-year fluctuations of the stock market are governed by unfolding, real-time economic and political events which must be predicted and understood by experts who will make adjustments to portfolios to enhance the "natural" returns of the market.

The empirical evidence on these matters is compelling and quite clear. Experts who are able to predict and interpret events and then invest insightfully from this knowledge are so few and far between as to be practically non-existent. The performance of mutual fund managers has been analyzed to death and every study confirms that manager skill is a "will of the wisp" with superior returns almost always reverting to the norm over time.

In addition, the Mid-Cap Power Index is often in bonds during time periods when the market is advancing dramatically. The behavior of the market in 2009 and 2010 between May and November is a case in point. The fact that the market is down 45% of the time during these periods is small consolation to investors watching stocks skyrocket while they miss the party. During these periods, it's hard to remember that risk management - avoiding large losses - is the primary objective of an intelligent, long-term investment program.

The Mid-Cap Power Index strategy has worked for the past 30 years because it exploits human psychology. Late in the year, the "experts" provide guidance for the next calendar year. This guidance, whether in the form of interest rate forecasts, earnings forecasts, or general economic trends, tends to be overly optimistic and also tends to be issued with great confidence. Nobody likes a wishy-washy forecast. We tend to think that forecasters don't know enough about their own business if they hedge their bets. Empirical studies bear this out - confidence inspires confidence. Unfortunately, empirical studies also show that the most confident forecasters are most likely to be wrong. (For a complete account of this, see "Future Babble: Why Expert Predictions Are Next to Worthless, and You Can Do Better" by Dan Gardner).

The upshot is that these optimistic forecasts normally translate into an elevated market "climate" at year-end and into the first several months of the year. These highly paid, overly confidenct "experts" inspire investors and lead to heightened expectations. About mid-year, reality begins to set in as the data begins to flow and the "experts" begin the annual ceremony of revising their forecasts downward. In good times, this phenomenon has very little effect on stocks; but in bad times, it compounds the prevailing negativity, producing big market corrections.