Might the stock market be undervalued? That would be remarkable if so, of course. Stock market bulls have long since given up hope of making that argument, since almost all of the standard valuation measures -- such as the price/earnings ratio, price/book ratio, and price/sales ratio -- have for years mostly shown the stock market to be trading somewhere between overvalued and extremely overvalued.
Yet a lesser-known model -- which is nevertheless solidly grounded in the historical data -- reaches a different conclusion.
I'm referring to work conducted by an investment advisory service called Investment Quality Trends, founded in the 1960s by Geraldine Weiss and currently edited by Kelley Wright. Twice each month over the past 5-plus decades, the newsletter has put into four categories several hundred dividend-paying stocks that are rated highly for financial safety and for having a long history of paying dividends:
- The "Undervalued" category contains stocks whose yields are close to the high ends of their historical ranges;
- The "Overvalued" category includes those whose yields are close to the low ends of their historical ranges
- The "Rising Trend" category includes those stocks that used to be in the "Undervalued" category but whose yields have fallen more than 10%;
- The "Declining Trend" group contains stocks that used to be in the "Overvalued" category but whose yields have risen more than 10%
Upon feeding into my PC's statistical package the relative size of these four categories since the mid-1960s, I found that one of the categories -- the Rising Trend category -- had a particularly strong relationship with the stock market's return over the subsequent three years. Indeed, the correlation between the two is significant at the 95% confidence level that statisticians often use when determining whether a pattern is genuine.
To appreciate the current implication of this finding, take a look at the accompanying chart: 36.5% of the blue-chip stocks on Wright's monitored list are in the Rising Trend category, versus a five-decade average of 31.4%. If the future is like the past, therefore, it could very well be that the stock market's return over the next three years will be above its historical average.
Kelley Wright, in an interview earlier this week, acknowledged that this conclusion might seem counterintuitive, given that the stock market is close to all-time highs. Indeed, as you can see from the chart, the Rising Trend category is larger today than at the beginning of this year -- despite the stock market's strong year-to-date performance.
But he argued that the bullish message of his data isn't as surprising as it might otherwise appear. Dividend increases for the highest-quality blue chips are running at an 8% annual clip, for example; other things being equal, such increases make stocks more undervalued from a dividend yield point of view.
Another reason the increased bullishness of the data this year isn't particularly surprising: The stock market's strong year-to-date performance was concentrated among growth companies rather than dividend-paying blue-chip stocks. The iShares Russell 1000 Growth ETF (IWF - Get Report) , for example, has gained 5.4 percentage points more this year than the iShares Russell 1000 Value ETF (IWD - Get Report) .
In any case, I should stress that Wright is not a short-term market timer. He instead concentrates on picking undervalued dividend-paying stocks that he believes are good bets for performance over the subsequent several years regardless of what the overall market does. Based on the performance of his model portfolios -- which are designed to be fully invested through thick and thin -- his newsletter is in first place for 30-year risk-adjusted performance among the newsletters monitored by my Hulbert Ratings performance tracking service. (Full disclosure: Investment Quality Trends is one of the newsletters that pays a flat fee to have its performance audited by my firm.)
Still, the bulls will no doubt find it welcome news that an historically-sound argument can be made that the stock market might even today, at close to all-time highs, represent good long-term value.
About the author: Hulbert was the founder of Hulbert Financial Digest. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at email@example.com.