Michael Santoli

Mom, Pop May Be Ready to Jump Into Stocks, but Some Signs Flash Caution

Michael Santoli

The stock market is hovering near all-time highs, prompting more retail investors to finally accept its enticing invitation to jump in. Yet the average stock doesn’t appear poised to please today’s buyer over the next few years.

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Reuters

That’s the message being flashed by one of the longest-tenured and most accurate market handicapping tools, known as the Value Line Median Appreciation Potential; it's calculated weekly by the esteemed Value Line Investment Survey research newsletter. In fact, only 10 prior times since 1970 has this indicator sent as sobering a message about prospects for the typical stock over the next few years as it is right now.

Value Line tracks some 1,700 stocks through mostly quantitative analysis of a company's past and projected earnings and its shares’ valuation, calculating for each one how they might perform over the next three to five years. The Median Appreciation Potential is simply the median of the percentage gains expected for all stocks covered.

An unintended market predictor

While not intended to be a market-prediction tool, it has worked nicely as one, especially for investors with a time horizon of a few years. Academic studies have ratified its value in this regard. The market-newsletter tracker Hulbert Financial Digest has ranked it first among market-timing services in forecasting four-year market performance.

Since 1970, the VLMAP, as it is known, has flagged the tremendous buying opportunities at the bear-market lows in 1974, 1982 and 2009, each time suggesting the median return potential was an annualized 25% or more over the next five years. That’s almost exactly how the Standard & Poor’s 500 index has performed in the four-plus years since the March 2009 market low.

Conversely, every time the number has fallen to its current 7% level – which is in the lowest 10% of all readings since 1970 – the broad market has been flat or down over the subsequent half-decade.

Granted, such a low reading has not always meant the market was at an ultimate top, so it is not a reliable short-term market-timing device. Specifically, when the VLMAP was near its current downcast level in the early 1970s and late ‘90s, the S&P 500 kept moving up nicely for a couple of years as very large stocks soared and propelled the index higher.

Major indexes well-supported

The major indexes appear well-supported and a rush of money chasing the all-time highs could easily help carry it higher as the impression broadens that the economy is improving. Markets, over the shorter term, overshoot, and bull markets frequently overshoot to the upside as the public embraces the upbeat story.

The real message at the moment is that the average stock in the market – and specifically small-cap stocks – appears fully valued at best and is unlikely on average to reward buyers at today’s prices over the next few years.

Don Hays of Hays Advisory made this distinction in a blog post early this year, explaining how the VLMAP – an “excellent gauge of potential appreciation” – was showing the market to be far less attractive than his own Hays Valuation Composite tool was. The Hays indicator focuses on large stocks and comparing stock multiples to interest rates and inflation trends, not on the broad list of stocks and their projected price-to-earnings ratios.

This should serve as a warning to investors flocking to the small-cap Russell 2000 index via the popular iShares Russell 2000 Index ETF (IWM), which is up 19% this year and more than 9% since June 24 alone. This index has been in favor as risk appetites have risen, and because its mostly domestic companies have ridden the flow of money playing the U.S. economic recovery and moving away from companies exposed to emerging markets and global trade.

The P/E ratio on the Russell 2000 as of June 30 was above 19, according to Russell Investments – and that excludes any companies that have posted a loss over the past year. That’s a two-point premium to the S&P 500 based on the past year’s earnings. So whatever “cheapness” so many commentators cite in U.S. stocks appears mostly evident in the very largest companies.

Sure, some will quibble that all stock valuation or market-handicapping efforts are being fouled by ultra-easy Federal Reserve policy and low interest rates. Even to the extent those things are driving stocks skyward, they won’t likely be in place over a five-year horizon.

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