This little-known indicator with an excellent record is projecting below-average long-term returns

This disheartening prediction comes from a valuation model that sports an impressive record predicting stocks’ subsequent five-year return. It is based on a single number published each week in the Value Line Investment Survey, the flagship newsletter published by Value Line, Inc.
VALU,
-2.22%
The number 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. This number is referred to as VLMAP, for Value Line’s Median Appreciation Potential. Though different VLMAP followers have different rules for translating the number into a particular market timing judgment, in general they increase and decrease their equity exposure levels in sync with the VLMAP.

The accompanying chart plots the VLMAP and the Russell 2000 index’s subsequent 5-year annualized return. The chart starts in 1979, since that’s when the Russell 2000 index was created. (The VLMAP itself dates back to the early 1960s.) I constructed this chart to focus on the Russell 2000 and a five-year forecast horizon because that is the index and time frame for which the VLMAP has the greatest explanatory power, according to my statistical tests.

Consider a statistic known as the r-squared, which measures the degree to which one data series explains or predicts changes in another. When the VLMAP is used to predict the Russell 2000’s subsequent 5-year return, the r-squared is a statistically significant 39%. The comparable r-squared is a still-statistically-significant 13% when the VLMAP is used to predict the S&P 500’s
SPX,
-1.05%
subsequent five-year return. When the VLMAP is used to predict subsequent 10-year returns, the r-squareds are 22% for the Russell 2000 and 14% for the S&P 500.

It makes sense that the VLMAP would have a better record when forecasting returns of the Russell 2000 than the S&P 500. Since the VLMAP focuses on the median stock, it will be more heavily dominated by smaller-cap stocks than the large-cap-dominated S&P 500.

The VLMAP currently stands at 55%, which is at the 37^th percentile of its distribution since 1979. The good news is that the VLMAP’s current level is a lot closer to the middle of its distribution than at the top of the bull market in 2021. That’s when the VLMAP sunk to an extremely low level of just 25%. But for one other week since 1979, there were no other occasions since 1979 in which the VLMAP was any lower.

The bad news is that the VLMAP is still below its median, suggesting a below-average return over the next five years. Daniel Seiver, editor of The PAD System Report investment newsletter and a member of the Economics faculty at Cal Poly-San Luis Obispo, has extensively analyzed the VLMAP’s historical track record. In an email, Seiver said that a VLMAP of 55% “is not that attractive, especially with interest rates still headed higher. I am happy to hold about 50% cash reserves, and cash now pays a lot more than it did two years ago. In 2020, the pandemic decline pushed the VL MAP well over 100%, offering long-term investors a terrific (albeit brief) chance to buy stocks at really attractive prices. On the other hand, in mid 2021, the VLMAP fell to 25%, which was a sign that stocks were severely overvalued. Not a bad long-term forecasting record.”

Mark Robertson agrees. He manages the Manifest Investing website, and has relied heavily on the VLMAP over the years. Even though the VLMAP underestimated the stock market’s returns over the last decade, he said in an email that a long-term chart of the two series is “still compelling.”

(Full disclosure: Neither Seiver’s nor Robertson’s services is among those whose track records are audited by my performance auditing firm.)

How other valuation models stack up currently

The VLMAP is not among the eight valuation indicators I regularly feature in this monthly review. These eight were picked because of their superior track records predicting the S&P 500’s 10-year returns, and the VLMAP comes up short relative to them. But its track record is still impressive, and its projection of below-average returns adds to the similar message that comes from those eight—as you can see from the table below.