By Mark Hulbert
The Russell 2000 Index, which tracks small- and mid-cap stocks, will be lower in a year’s time, according to the indicator I follow that has the best record forecasting the stock market’s 12-month returns.
The indicator, which says the index /zigman2/quotes/210598147/delayed RUT -3.81% will be 1.1% lower, is based on a number that appears each week in the Value Line Investment Survey. Known as the Value Line Median Appreciation Potential, or VLMAP, this statistic represents the median of the projections made by Value Line’s analysts of where the 1,700 widely followed stocks they closely monitor will be trading in three to five years’ time.
You may legitimately wonder why we should give this indicator the time of day, since it has proven recently to be too bearish. When I last reported on the status of the VLMAP , six months ago, it was projecting that the Russell 2000 would be just 0.1% higher in a year’s time. Though we still have six months left on that prediction, it certainly appears as though the VLMAP was too pessimistic. The Russell 2000 Index is 21.9% higher today than then.
For insight, I turned to Dan Seiver, an emeritus professor of economics at Miami University (Ohio) and an economics lecturer at California Polytechnic-San Luis Obispo. For three decades he has published a financial newsletter based on the VLMAP, titled The PAD System Report. (Disclosure: Seiver does not use my firm to audit his returns.)
His answer, in short, is that we should pay attention to the VLMAP because of its excellent long-term record. He documented that record in a study that appeared in the Journal of Wealth Management in 2013 .
To appreciate the VLMAP’s track record relative to other well-known indicators, I constructed a simple econometric model that used the VLMAP to forecast where the Russell 2000 would be in a year’s time. Since 1978, when this benchmark was created, the VLMAP has been able to predict 21% of the variation in subsequent 12-month returns. In contrast, when I constructed a similar econometric model that used the price-to-earnings (P/E) ratio to forecast the market’s 12-month return, I found that it explained just 0.2%. The same conclusion was reached when I compared the VLMAP to any of a number of other valuation indicators.
Putting the VLMAP into use
In Seiver’s Journal of Wealth Management study, he also reported that an investor could beat a buy-and-hold strategy by increasing equity exposure when the VLMAP is high and reducing it when it is low. Right now that means being largely in cash, since the VLMAP is at one of its lowest levels ever. Fewer than 3% of weekly readings since 1966 have been lower.
In an interview, Seiver said: “There has never been a U.S. bull market since the 1960s that ended with the VLMAP not in my sell zone.” Similarly, “there has never been a bear market that ended with the VLMAP not in my buy zone.”
That doesn’t mean bull markets immediately start or end whenever the VLMAP rises or falls into his buy or sell zones, Seiver hastened to add. But when a bull market pushes the VLMAP into the sell zone, where it is now, it represents an unattractive risk/reward tradeoff. The key to using his market-timing system is therefore having the patience and discipline to concentrate buying when the VLMAP is high and concentrate selling when the VLMAP is low, and sit on one’s hands for the sometimes long periods of time in between.
Current status of valuation indicators
I also want to report the latest values of the eight indicators I track each month in this space, my monthly review of the status of various valuation indicators with the best record predicting the stock market’s 10-year returns.
The three columns on the right show the latest valuations for the time periods indicated, with 0% being the most bullish and 100% being the most bearish:
As you can see, their almost-unanimous message is that the stock market’s longer-term prospects are not good. Coupled with the bearish short-term forecast of the VLMAP, they paint a sobering picture.
For a full description of how each of the indicators is calculated, please refer to my Oct. 30 column .
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at firstname.lastname@example.org .