The days of easy money in the U.S. stock market could be behind us.
That sobering assessment seems out of step with this past week’s developments after the Federal Reserve’s surprise decision to continue its massive bond-buying program quickly propelled markets to new records.
But making money over the long term often requires investors to defy the conventional wisdom.
Now may be just such a time, according to one newly developed indicator that attempts to identify both when it is safe to allocate more funds to the stock market and when equities should be avoided altogether — as well as the stages in between.
If the indicator is correct — and extensive historical testing has shown it to be prescient — investors might want to begin selling their riskiest positions and adding to their holdings of safer and more-conservative stocks.
This new indicator is the brainchild of Vincent Deluard, an investment strategist at Ned Davis Research, a quantitative research firm in Venice, Fla. It is constructed by adding the inflation rate, the unemployment rate and the S&P 500’s price/earnings ratio based on trailing 24-month earnings.
The stock market historically has performed far better when this indicator has been lower than higher. Its median level since 1930 is 26.7, Mr. Deluard reports, and the S&P 500 has produced an annualized return of 14.6% following indicator readings below that median, assuming dividends are reinvested. By contrast, the S&P has returned just 4.7% annualized whenever the indicator is above that median.
The indicator’s success comes from relating investor sentiment to underlying economic fundamentals. For example, investors can fairly safely assume that stocks are a bargain whenever valuations are low, as indicated by a low P/E ratio, and economic growth is strong and sustainable, as indicated by low rates of inflation and unemployment.
By the same token, the stock market is in a high-risk zone whenever the P/E ratio is high while the economy is weak. That would suggest “an irrational exuberance that is not conducive to much-higher stock prices,” Mr. Deluard says.
The current stock market is in this high-risk zone now.
To be sure, the indicator — which now stands at 28.1 — isn’t very far above its long-term median, and it could well fall back into more-favorable territory in the near future. The most likely way for that to happen would be through a lower market P/E ratio, since it is hard to see how the indicator will receive much help from either the unemployment rate or inflation.
How might we get a lower P/E? One way would be for earnings to rise faster than the market, of course. Another would be for the market itself to fall significantly, though that may seem unlikely after this last week’s surge to all-time highs.
One drawback of the new indicator is that even overpriced markets sometimes rise for months — even years — before eventually succumbing. The latter half of the 1990s is a good case in point. By early 1998, the indicator already was above 34, higher than 90% of comparable readings back to 1930. And yet the stock market continued higher for two more years, before plunging when the Internet bubble burst in early 2000.
Followers of this new indicator will therefore need to be prepared to at least partially sit out such rallies as one price to pay for hopefully avoiding big losses when the market does head south.
You also should keep in mind that it is important to look at the weight of all evidence, rather than focus on any one indicator in isolation — no matter how good its track record.
That said, the investment implication is to exercise caution. Consider the stocks that performed well in the past when the indicator was close to where it stands currently. According to an analysis conducted by the Hulbert Financial Digest, the best performers during such periods were so-called large-cap-value stocks — those with market capitalizations that are among the biggest on Wall Street and which also are trading for low price/book ratios.
The stocks of these companies tend to be safer and more conservative and often sport handsome dividends. To identify which of them are currently attractive, it is helpful to turn to the select group of advisers among those tracked by the Hulbert Financial Digest who have beaten the stock market over the past 15 years. Currently they are recommending a handful of nonfinancial large-caps with price/book ratios of 1.5 or below. (The S&P 500’s comparable price/book ratio currently stands at 2.5.)
They are natural-gas producer Chesapeake Energy CHK, +8.35% with a price/book ratio of 0.9; Exelon EXC, -0.50% the giant utility, with a 1.2 price/book ratio; Hewlett-Packard HPQ, +0.98% the computer maker, with a 1.2 price/book ratio; and two oil companies each with 1.5 price/book ratios: Chevron CVX, +3.20% and ConocoPhillips COP, +6.97%
To be sure, there are reasons why each of these companies is out of favor and trading at a low price/book ratio. Nevertheless, in each case several of the market-beating advisers believe the stock is attractive for purchase.
Another country whose stock market appears cheap is Norway. The iShares Norway Capped ETF, which tracks that market, has an expense ratio of 0.53%.