Indicator Sounds Stock Market Warning Bell

I rarely look at stock tips and outside research. That being said, there is one indicator/number I like to keep an eye on and that is the VLMAP. Two months ago I warned about the VLMAP hitting 35% … it is now lower and more worrisome at 30%. The last time it was this low was 40 years ago and the track record for this indicator is nearly perfect. I think it would be foolish to hold on to a portfolio with beta > 1.10 at this time and bet against this indicator. My gut tells me portfolio managers should get down closer to 1.00. That means you will still be in the game but you may under-perform your peers if the market goes higher from here (and vice versa), as the straight average for a name in the S&P is actually above 1.10. I understand short covering, performance chasing, low interest rates, margin debt, exuberance and other factors could drive this market higher, but we are at this point borrowing from future years gains and it is nearly certain that those on the sidelines could exit positions now as I have been doing and repurchase at lower prices at a later date.

The VLMAP model comes from Dan Seiver, a member of the economics faculty at Cal Poly State University. Seiver also is editor of an investment advisory service named The PAD System Report. Though Seiver created the model nearly 30 years ago, he recently co-authored an academic study of the model's effectiveness that appears in the current issue of the Journal of Wealth Management.

Seiver's model is based on a single number that is published each week in the highly regarded and followed Value Line Investment Survey. 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. Followers refer to this number as the VLMAP, which stands for Value Line's Median Appreciation Potential.

The model Seiver devised using VLMAP considers the risk-reward ratio for stocks to be attractive enough to warrant investing new money in the market only when it rises to at least 100 (%). When it drops to 55, in contrast, it is time to begin building up cash.

The VLMAP just hit 30%. The last time it was this low … but not quite this low … was at the top of the bull market in 2008 when it dropped to 40 (%). This is one of the worst readings recorded since I was born (1967). When the indicator broke below 40% in the past, it usually preceded months or years of poor stock returns and I do not believe this time will be different.

When the market was bouncing off the crash (2009-2012) I was looking to hit doubles and triples. With the market now > 1800 I am content with singles and doubles. Currently, 70% of the names in the S&P-500 are trading at or above their respective 5-year average P/E ratios and 60% are at or above their respective 10-year average P/E ratios. Nearly half of the S&P-500 names are now trading more than 20% above their respective 5-year average P/E ratios and 25% of the S&P-500 is trading more than 20% above their respective 10-year average P/E ratios.

I got very aggressive when the S&P was trading in the 1250-1500 range last year. In fact I added/reinstated 29 names in the second half of 2012 (and only dropped a few). Since we crossed 1700 two months ago I have been with a defensive bias but kept portfolio beta above 1.0 the entire time as it is ill-advised to time the market and fight the tape (and other factors pushing the market higher). In the second half of 2013 I have added 24 names but have dropped quite a few, so the net change in the number of open recommendations here is in decline versus the second half of last year when it increased sharply.

I dropped Oracle (ORCL) on Wednesday - that was the fourteenth name I have dropped from Buy to Hold since October 1 and follows American Railcar (ARII), Omega Protein (OME), Spirit Aerosystems (SPR), Parker Drilling (PKD), Expedia (EXPE), Corning (GLW), DeVry (DV), U.S. Steel (X), TIM Participacoes (TSU), New York Community Bancorp (NYCB), Delta Airlines (DAL), Coach (COH) & Tempur Sealy (TPX).

It must be made clear - and this where many misinterpret the VLMAP indicator - this indicator is not a short-term market-timing tool. The stock market can continue to rise for months, if not years, after a sell reading as we are getting now. It is across a three-to five-year time horizon that the model has a batting average of nearly 100% going back more than 40 years. In other words if you exit now you will eventually be able to get back in at a lower level … especially with high beta names. In other words, regardless of how much higher the market goes in the near term, most names will only be ~ 25%-35% higher in 2017-2018 than where they are now. In my opinion, the S&P will be at 2500 by the end of the decade but we will probably see 1500 before we see 2500. The VLMAP is closely correlated with my own indicator - the number of open recommendations here at Standpoint Research. During the last ten years we have been in the 50-100 range … 85-100 at market lows … 50-65 at market highs … we are now at just 61. At the market low in March 2009 the VLMAP was at 185 (%) and that is almost exactly what the market did since we hit 666 on the S&P … a 175% move.

This indicator's greatest predictive power comes when forecasting the market's level looking out three-to-five years. It does not say how the market gets there from here. So the indicator's bearish level does not guarantee that a top has been seen.

Another highly regarded analyst who has recognized VLMAP's potential is Peter Bernstein, publisher of an institutional newsletter called Economics and Portfolio Strategy. Research he conducted in the 1980s and 1990s led him to conclude that the VLMAP has an excellent track record forecasting the stock market's level looking out ~ four years.

Seiver's and Bernstein's confidence in VLMAP prompted the Hulbert Financial Digest to conduct an extensive econometric analysis of its own into the VLMAP's potential as a market timing indicator and I must credit Mark Hulbert for some of what is in this e-mail. That HFD study, conducted in the summer of 2004 confirmed Seiver's and Bernstein's findings.

Weekly data for VLMAP exists back to the late 1960s. Since then, it has ranged from a low of 17 to a high of 255. It has however oscillated in a narrower range in recent years. Over the past 25 years, its low point is where it is now at 30, and its high of 185 coincided with the 2009 market bottom.

The market-timing system that Seiver devised using VLMAP considers the risk-reward ratio for stocks to be attractive enough to warrant investing new money in the market only when it rises to at least 100 but I think that is a bit high. I see value in this market when it drops to the 50s and 60s.

It reached 100 three times this decade: Following the 2008 crash … Immediately following the September 11, 2001 terrorist attacks, and at the end of the 2000-2002 collapse. In all three instances the stock market was markedly higher three-to-five years later. I think it would be a mistake to wait on the sidelines for the indicator to hit 100 again … that would imply S&P below 1200. I would be gradually lowering portfolio beta at this time … selling into the rally. In a correction and a break towards 1500-1600 I would go in the other direction and start gradually increasing portfolio beta. When the S&P dropped below 1400 in November 2012 I got very aggressive and I am hoping to get another shot at that price point before all is said and done.

I do not lose any sleep at night worrying about a market correction. The portfolio beta on our equally weighted list of 61 open recommendations is 1.10 and only seven names are trading with no earnings or a P/E above 17X. I have seen client portfolios where the beta is near 1.20 where one-third of the names are with no earnings or with P/E ratios at or above 20X and those are the people this caution is targeted at. If you have a concentrated portfolio then you must be even more careful.

If you have not yet seen a video of my Bloomberg television appearance from November 19 here is the link.

	# of Recomm-
Firm	endations	Accuracy	Rank
STANDPOINT	382	68.58%	1
RESEARCH
Raym James	233	61.57%	22
KeyBanc	613	58.52%	36
BB&T	417	55.15%	46
Sterne Agee	373	54.82%	50
Janney	332	54.69%	53
MKM	173	54.17%	58
Bank of Amer	939	53.28%	66
Citigroup	1257	52.81%	68
Credit Suisse	1502	51.33%	84
JPMorgan	1404	50.30%	98
RW Baird	1092	48.55%	121
Needham	694	48.35%	124
Goldman Sachs	1060	48.33%	125
Wedbush	663	47.69%	135
HSBC	331	47.45%	136
FBR	1206	47.35%	137
Piper Jaff	644	47.30%	138
Wunderlich	418	46.08%	149
Brean Murray	521	45.45%	153
Maxim Group	242	40.93%	179

Source: Indicator Sounds Stock Market Warning Bell

Disclosure: I 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. (More...)

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