In our last newsletter, I took a swipe at the Efficient Market Theory. If you remember, this theory states that the market is priced efficiently, meaning that all useful information is already incorporated in stock prices. In addition, new information is rapidly digested by millions of investors and incorporated into prices in short order. Therefore, it is virtually impossible to "beat the market" since information drives prices and no one can consistently outwit the millions of minds which are constantly processing new information.

The upshot of this theory is that the market is "random" and "unpredictable". At the same time, however, the theory assumes that stock prices will rise over the long-term, reflecting the growth of corporate earnings in a more or less free-market economy.

My response was that this viewpoint misses the point. By focusing on information processing the theory misses the true driver of stock prices - human nature. Understanding human nature opens the door to market "predictability".

Our view is that the market is profoundly affected by cyclical forces which alter investor sentiment in predictable ways. In particular, these cycles cause a "skewing" of market returns into time periods which I call "power zones". A power zone is a cyclical time period when investor confidence is on the rise, causing a positive investment "climate". During these periods, investors view events through rose-colored glasses and tend to ignore developments which are "bad". Thus the expression, "A bull market climbs a wall of worry."

One of these cyclical forces is the four-year presidential election cycle. As I pointed out in the last newsletter, the third year of the presidential term - the pre-election year - hasn't been down since 1931 (total return, Dow Industrials). The average appreciation of the market in the third year is 17.5%, more than three times the average of the other three years. Moreover, the fourth quarter of the president's second year - the quarter containing the mid-term elections - is exceptionally powerful, averaging a 7.5% appreciation. Combine these two periods and you get a 15-month "power zone" which hasn't been down since 1931, averaging a 25% appreciation plus dividends.

This is about as non-random as you can get.

The mid-term elections trigger a change in political ambitions in Washington, D.C. Politicians and their allies now focus on the next presidential election and they begin to woo the electorate with promises of fiscal responsibility, balanced budgets, lower taxes, less legislative activism, and government reform. When possible, the Fed joins in to keep interest rates low and/or stable and provides plenty of liquidity to the banking system. The entire political establishment is aiming for the same thing - a good economy at election time.

This shift raises investor confidence and produces the statistical "skewing" of returns into the 15-month "power zone". Typically, this optimism spills over into the election year, as well.

In the last newsletter I pointed out that investment strategies which take advantage of the predictability in human nature can prosper during long periods of investment malaise. The past ten years certainly qualifies, as does the almost 20-year period from the mid-sixties to the mid-eighties, when the Dow stalled out at 1000 multiple times, before finally taking off in 1983.

The table below shows the total return of the S&P 500 during the election cycle power zones from 1954 until now.

As you can see, during the secular bear market of 1965-1983 which was characterized by rising and high inflation, rising interest rates, Vietnam, student unrest, the counter-culture, Nixon, and other various and sundry problems, the S&P 500 delivered consistently high returns during election cycle power zones. The NASDAQ index did even better. An investor who held stocks only during these periods and intermediate treasuries the rest of the time would have breezed through one of the most difficult investment climates in history with almost continuous gains.

The same is true of the past decade, which has turned out to be one of the worst ten-year periods of the last 100 years.

Two of Alpha's programs depend heavily on this powerful cyclical force - The Formula^TM and the E-System Portfolio. Both programs are now in bonds waiting for early October and the arrival of the next election cycle power zone.