Octobers Past and Present: A Potential Window to Future Returns

By Tom Madell

It seems to me that one of the main purposes of a mutual fund/ETF newsletter should be to try to help investors get good returns on their investments. And that is what I have tried to help investors do year after year since this Newsletter's inception in 1999. The evidence suggests that I have been, by and large, able to accomplish this goal.

Realistically, I would be lying if I didn't point out that you can typically get these kind of good returns without ever reading my Newsletter. How? Just by merely investing in some of the best index funds (or ETFs if you prefer them). Of course, my Newsletter has more than just names of specific fund choices, both index and non-index, I believe will be performance-enhancing additions to one's portfolio; I also include recommendations as to whether I think a specific fund, or category of funds, should currently be a relatively big part of your portfolio or not.

But as all investors should realize, owning index funds cannot guarantee better returns or certainly not prevent potential losses. When the overall market starts to fall, index funds too will be hit. Just how much they may fall or whether they will fare better than non-index funds is something that cannot be predicted with certainty beforehand.

So all investors must embrace the reality of risk, the possibility that their investments may fall and possibly cause them to lose rather than make money. Thus although the stock market may not have seemed very scary lately, there is always the potential for at least a temporary resurgence of price drops in various types of funds which investors may not have anticipated in either magnitude or length. Will such an outcome cause at least some investors to flee these investments, selling at sub-optimum prices for fear of further losses and thereby possibly miss out on the gains most likely eventually enjoyed by long-term investors?

The best protection against such a performance robbing outcome is what we have always been told - stay diversified in a variety of investments so that losses in any one have a better chance of being offset by better performance in another. Of course, being well-diversified may result in somewhat less stellar returns when things are going extremely well, as they have been lately, since you are not putting all your bets just on current winners. But over the long haul, being well-diversified in a variety of different types of funds appears to be a safer and potentially more winning strategy than putting all your unswerving trust in just a few types of funds.

Getting back to fund recommendations made to readers of this Newsletter, I make such stock fund recommendations 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. (Click here if interested in reviewing the findings.) The findings of this research have been extremely helpful for the most part since then, especially in identifying outstanding Buy opportunities.

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 stocks 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:

You can see that buying the average fund in any of these categories at the start of the period and holding thru 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.

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.

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 this 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 a few 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 around, 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.

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 funds 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.

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