Baylor pair's model says returns likely to be 'well below average'


Bad news, stock investors: The market is likely to underperform garden-variety money market funds through the end of next year.

That gloomy forecast comes from a market-timing model that, while not perfect, has had an impressive track record over the long run.

The model arose from research conducted about 15 years ago by William Reichenstein, a professor of investments at Baylor University, and Steven P. Rich, a finance professor at Baylor. They reported their results in an article in the summer 1993 issue of The Journal of Portfolio Management.

The model is quite simple, especially when compared with many econometric models. It has three ingredients: the stock market's dividend yield, the interest rate on 90-day Treasury bills and the median of projections from analysts at Value Line, the investment research firm, of how much the 1,700 stocks they monitor will appreciate over the next three to five years.

The first two numbers are readily available at many financial Web sites, and the third is published weekly in the Value Line Investment Survey. The formula for combining the three pieces of data can be easily figured with a spreadsheet program or a calculator.

Despite the model's simplicity, the professors found in back testing over the period from 1968 through 1989 that its periodic readings had done an impressive job of forecasting the stock market's gains and losses over the subsequent six calendar quarters.

To be sure, the model has had a mixed record in the 13 years since their study appeared. Though the model has performed well in the current decade, its record in the 1990s was poor. Through much of that decade, it projected below-average performance for the stock market, thereby greatly underestimating equities' returns.

The model's failure in the 1990s, however, may be the exception that proves the rule.

In an interview, Reichenstein contended that the stock market's outsized returns in that decade were in large part attributable to investor "irrationality," and that the model should therefore not be faulted for failing to forecast them. The model aims to forecast what the market's level would be if investors were rational, and "no model built on rational pricing is able to explain irrational behavior," he said.

A study by The Hulbert Financial Digest provides further support for the notion that the model's failure during the 1990s was an anomaly.

The study focused on its performance from 1968 through 2006 - a period that includes the 22 years covered in the professors' original study and the 17 years since. Even after the incorrect forecasts in the 1990s are taken into account, the model's overall record is good enough to be statistically meaningful and not likely to be mere luck.

So what does the model say about the current state of the stock market? Unfortunately, the message is pessimistic. In fact, it has been more bearish only 15 percent of the time since 1968. Specifically, it projects that the total return of the Standard & Poor's 500-stock index over the next six quarters will be 1 percentage point below that of riskless 90-day Treasury bills. Because those bills, at current rates, are expected to produce a 7.5 percent return over the next six quarters, that would mean a total S&P; 500 return of about 6.5 percent - equal to about 4 percent, annualized.

Reichenstein emphasized that because so many factors would influence the stock market over the next six quarters, we should not place too much weight on the exact number of his model's forecast. But, based on its current low reading, he said, he is confident in forecasting that the stock market's return from now to the end of next year will be "well below average."

One investment adviser who bases his market timing in part on this model is Dan Seiver, who publishes a newsletter called the PAD System Report. He is also an emeritus professor of economics at Miami University of Ohio and is a visiting professor of economics and finance at San Diego State University and the University of San Diego. Seiver writes that the model's recent level "matches the reading for the second quarter of 1987 [before the crash], and is fairly close to the reading for the fourth quarter of 1968 [before a six-year punishing bear market]."

He also points out that the model's current reading is far lower than it was at the beginning of bull markets. In the second half of 1982, for example, before the great bull market of the 1980s, it projected a six-quarter equity return that was 15 percentage points higher than today's forecast. The projection from late 1974 was more than 30 percentage points higher than today's.

"You can draw your own conclusions, but these numbers make us very afraid," Seiver writes. "Expect weakness or worse over the next year."

Mark Hulbert is editor of the Hulbert Financial Digest, a service of MarketWatch.

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