The bulls have gotten used to being told that the stock market is more overvalued than its been in years.
So what else is new? they typically ask when presented with yet another indicator showing overvaluation.
Well, heres something that should get even their jaundiced attention: According to one valuation model that has a stellar long-term record, stocks are now more overvalued than they have been since 1969 almost half a century ago.
The model to which I refer is based on a single number published each week in the famed Value Line Investment Survey, published by Value Line, Inc. The number represents the median of the projections made by Value Lines analysts of where the 1,700 widely-followed stocks they closely monitor will be trading in three- to five years time. Followers refer to this number as the VLMAP, which stands for Value Lines Median Appreciation Potential.
A number of academic studies have found that the VLMAP can be profitably used as a market-timing tool. The model calls for increasing your exposure to the stock market when it is at well-above-average levels and decreasing exposure when as it is now its well below average. One such study appeared in the Journal of Wealth Management in 2013, co-authored by Daniel Seiver, a member of the economics faculty at Cal Poly State University and editor of an investment advisory service named The PAD System Report.
The VLMAPs current level is 20%, far lower than its long-term average of near 75%. At the bottom of the bear market in March 2009, in contrast, the VLMAP stood at 185%. Seiver currently is allocating 60% of his model portfolio to cash; in March 2009 he was fully invested.
To be sure, the VLMAP has been below average for a number of years now, even if it hasnt been as low as it is currently. Seiver, in an interview, acknowledged that its difficult to say anything about the markets overvaluation that hasnt already been said. He simply reminded us, quoting John Maynard Keynes, that the market can remain irrational longer than you can remain solvent.
How good of a track record does the VLMAP-based market timing model have? One measure comes from the success of a simple econometric model that uses the VLMAPs level to predict the stock markets level four years hence. A Hulbert Financial Digest study several years ago of VLMAP data back to 1966 reported an r-squared of 0.43 when used to forecast the Value Line Geometric Index. Thats highly statistically significant.
(To be sure, this r-squared is lower than the 1.0 that it would have been if the VLMAPs forecast record was perfect. But no indicator is perfect, and a 0.43 reading is far higher than many of the other models that capture Wall Streets attention.)
Why does the VLMAP have as good a track record as it does? Probably because Value Lines analysts, by focusing on the longer term of between three- to five years hence, are relatively immune from the sentiment swings that are induced by short-term price movements. As a result, the VLMAP goes down whenever prices go up without a concurrent increase in a companys long-term earnings prospects and vice versa. Thats exactly what a good market-timing model should do.
Still, as the last several years have illustrated all too well, the stock market could continue rising in the face of a low VLMAP reading. But the evidence of overvaluation continues to accumulate. Someday, the sheer weight of that evidence will be too much for even this bull market to bear.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email firstname.lastname@example.org .
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