Octobers Past And Present: A Possible Accurate Predictor Of Future Returns

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Includes: VEIEX, VFINX, VIGRX, VISVX, VTSMX
by: Tom Madell
Summary

Research suggests that there are known better and worse times to invest in stocks if you wish to get the best returns over the longer term.

You will likely achieve better long-term results when you take into consideration valuation when investing.

This article compares returns achieved following my recommendations made in October 2012, 2013, and 2014, finding 2012 was the best time to invest.

While index funds have yielded some of the best returns between 2012 and 2017, they now appear overvalued.

I make stock fund/ETF recommendations for my newsletter's model portfolios based on how well I expect funds to do over the next 3 to 5 years. The basis for such recommendations is past research I conducted a number of years ago that attempts to help to determine when a fund or a fund category is a currently what I call a Buy, Hold, or Sell. The findings of this research have been extremely helpful for the most part since then, especially in identifying outstanding Buy opportunities. (Click here to read the study.)

Of course, I wish I could also identify a reliable way to at least somewhat accurately predict how stock funds might do over shorter time periods, but my research has yet to come up with an answer. Stock fund performance, it seems, is just too variable over periods of just a few years to allow such predictions to be any more accurate than just guesses, with the probability of being correct akin to using a coin flip to predict winners and losers.

So how can I gain an advantage over mere guesswork in attempting to predict relatively good vs. less good returns when pushed out over the next 3 to 5 years? To me, it basically boils down to trying to recognize when stocks are reasonably valued, or even undervalued, vs. when they are overvalued.

My research, referenced above, shows that when fairly valued or undervalued, it is reasonable to expect stock funds to do well, while when overvalued, they likely won't. Of course, this shouldn't really be considered rocket science. Researchers who have extensively studied stock returns, including Nobel Prize economist Robert Shiller, have found that an highly overvalued market, while able to remain overvalued for some time, tends to eventually yield underperforming longer-term returns. On the other hand, it follows that an undervalued market, or certain segments within it, while remaining undervalued for sometimes long periods, tends to eventually yield overperforming longer-term returns.

To try to objectify this, my research went back over a substantial number of years for which I had data and helped me to identify some key past performance points that, at least in the past, have been associated with strong vs. relatively weak future performance.

Octobers Past

In fact, in the time elapsed since the current bull market began more than 8 1/2 years ago, my research, at various points, indicated it was an excellent time to add to your stock fund holdings, although not so in the last few years. On the most recent of these occasions, in Oct. 2012, my data offered a rare signal suggesting to buy virtually all categories of stock funds. That's why in my Oct. 2012 newsletter, I recommended a very high allocation to stocks regardless of whether you were an aggressive, moderate, or even a conservative risk investor.

However, by a little more than a year later, namely in mid-Oct. 2013, my data argued for more caution, suggesting reducing or even selling some of the same funds. As alluded to above, it appeared that overvaluation was beginning to set in, possibly limiting future returns.

On the more positive side, by near the end of 2014, my data was looking somewhat more optimistic, suggesting that maintaining your stock positions in spite of still relatively high valuations was now your best course of action.

Each of these data sets from 2012, 2013, and 2014 represented a "snapshot" of how the stock market appeared at that juncture. So you might think of these projections as suggestive of how appealing the stock market's forward-looking prospects were at that particular time. Since the market is dynamic and ever changing, prospects might be good at one moment but not as good a short time later.

You might compare these results to a political poll: At one date, Candidate A candidate might be shown to have the best chance of winning, at another, it might be Candidate B. The changing of the predicted outcome might reflect just how uncertain the final outcome might be as compared to a poll that consistently predicted the same winner. But if the poll was accurate, one would still want to predict that the leader at the time of the latest poll would be the winner. Things change so you would want those changes to be reflected in your latest guess as to the now current probable winner. Likewise, as stock market conditions change, if you felt the need to change your investment outlook, you would want to go with the latest projection.

But unlike in political polling where Election Day is known, in investing, we shouldn't say that, say, a bullish outcome was likely vs. a bearish one without indicating a time period with which to judge the outcomes. History has shown that over the extremely long haul (i.e. many decades), no matter when one entered the stock market, the results would have nearly always come out well. But, again over the long haul, the eventual results would have been best if one had concentrated more of their purchases when valuations were relatively low vs. when they were relatively high. Of course, fair valuations or even undervalued ones tend to be associated with relatively low stock prices while overvaluation tends to mean high prices. This suggests that, if one was investing as far back as Oct. 2012 which most readers likely were, 2012 should have been a better time to invest than in either Oct. 2013 or Oct. 2014 in terms of best eventual 3 or 5 year results, according to my research data.

How accurate did these three sets of Oct. recommendations/predictions made in 2012, 2013, and 2014 turn out to be? And what does the latest "snapshot" taken on Mon. Oct. 30, 2017 suggest for future stock returns?

In Table 1, you can see how most major categories of stock funds have done since Oct. 2012 over the following three and five years:

Table 1. Results For Investments Made Beginning October 2012

Fund Category

3 Year
Return

5 Year
Return

Large Blend

11.3

12.9

Large Growth

12.9

13.9

Large Value

10.6

12.4

Mid-Cap Blend

12.0

12.8

Mid-Cap Growth

12.1

12.8

Mid-Cap Value

12.5

12.8

Small Blend

10.5

12.8

Small Growth

11.3

12.6

Small Value

9.8

11.9

International

4.7

7.9

Note 1: All returns are for mutual fund category averages, annualized.
Note 2: For comparison, the S&P 500 Index returned 12.4 (3 yr.); 14.2 (5 yr.)

You can see that buying the average fund in any of these categories at the start of the period and holding through the entire period, with the possible exception of International stocks, would have led to excellent results.

To examine if my recommendation to lighten up on stocks in Oct. 2013 would have been followed by lower returns justifying the move over the following years, see Table 2 below. Obviously, only if stocks did not do well over the following 3 to 5 years would that prove to have been a wise move.

For certain categories of funds, such caution did indeed turn out to foreshadow lower returns. For example, International funds barely budged over the following 3 years. Likewise, small cap funds in general also put in a sub-par performance.

Other categories have done somewhat well as measured 3 years later, although results haven't been nearly as good as shown in Table 1. Over the 4th year since the recommendation (2016-2017), stocks did do quite well. However, since no full 5 year returns are yet available for another year, the caution may still turn out to have had some merit for longer-term investors if stocks wind up dropping sharply between now and Oct. 2018.

Table 2. Results For Investments Made Beginning October 2013

Fund Category

3 Year
Return

Large Blend

8.9

Large Growth

10.0

Large Value

7.8

Mid-Cap Blend

7.1

Mid-Cap Growth

6.4

Mid-Cap Value

7.5

Small Blend

5.9

Small Growth

4.9

Small Value

5.5

International

0.7

Note: S&P 500 Index returned 11.2, annualized.

Finally, since Oct. 2014, when my forecasting data starting looking a little better, the latest 3 yr. fund category returns have improved from those shown in Table 2, as shown in Table 3. However, 5 year returns won't be available for 2 more years which might change the picture.

Table 3. Results For Investments Made Beginning October 2014

Fund Category

3 Year
Return

Large Blend

9.1

Large Growth

11.0

Large Value

7.8

Mid-Cap Blend

8.4

Mid-Cap Growth

9.2

Mid-Cap Value

7.9

Small Blend

10.2

Small Growth

10.7

Small Value

8.8

International

5.3

Note: S&P 500 Index returned 10.8, annualized.

Summarizing, research suggests that there are known better and worse times to invest in stocks if you wish to get the best returns over the longer term. The application of my specific research aimed at identifying over- and undervaluation in stock mutual funds, again, as in past articles in my Newsletter, shows that you will likely achieve better long-term results when you take into consideration valuation when investing.

The above data does show that over the last 3 and 5 years, the S&P 500 index has done better than the average investment in almost all other fund categories. (Note, however, that one cannot invest in an index itself. The closest you can come is investing in a S&P 500 index fund which, due to its expense ratio, will almost always perform slightly worse than the index itself.)

However, many index funds/ETFs such as those mirroring S&P 500 are now overvalued according to my research, while most fund category averages are somewhat more fairly valued (see below). Index funds, by their very nature, do not take into consideration valuation, just whether the included stocks are part of an external index. Therefore, in future years, such index funds may underperform, while more fairly valued, or even undervalued funds, may outperform.

October Present

Now that another Oct. has rolled past, investors will be interested in what my research data suggests for future returns. So, Table 4 shows which categories of funds now seem to have the best potential going forward over the next three to five years.

Table 4 lists the same fund categories as above. In this case, all categories are considered Holds except for Large Growth. Additionally, the categories are ordered from those that appear to have the best return potential to those with a lower potential. Note, however, that the Holds are closely bunched together in terms of return potential.

Table 4. Current Fund Category "Snapshot"

Fund Category

Recommendation

Mid-Cap Growth

Hold

Small Growth

Hold

International

Hold

Small Value

Hold

Mid-Cap Blend

Hold

Small Blend

Hold

Large Blend

Hold

Large Value

Hold

Mid-Cap Value

Hold

Large Growth

Reduce/Sell

While all categories of funds, except Large Growth, are seen as Holds, it should be noted that some of the most popular domestic index funds look overvalued. As noted above, these index fund are composed of stocks included regardless of valuation, and no matter how overvalued these stocks become, they will remain included in the fund.

For example, my research regards funds such as Vanguard Total Stock Market Index (VTSMX), Vanguard Index 500 (VFINX), Vanguard Growth Index (VIGRX) as overvalued, with others such as Vanguard Small Cap Value Index Fund (VISVX) on the verge of overvaluation. Note: My latest Model Stock Portfolio includes some of these overvalued funds although they represent a small portion of the Portfolio as compared to the International index funds included which are either fairly valued, or even undervalued as is the case with the Vanguard Emerging Markets Index (VEIEX) which alone is considered a Buy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have positions in all of the specific mutual funds mentioned in this article, except VISVX.