Friday, June 8, 2012

Market Significantly Undervalued

by Mark Hulbert

The stock market is more accurately described as undervalued than overvalued.

That is the comforting conclusion I reached upon analyzing a unique dataset of dividend-paying blue chip stocks back to 1966. My finding suggests that the stock market is poised to produce above-average returns over the next couple of years.

The dataset is the product of an advisory service called Investment Quality Trends, whose current editor is Kelley Wright.

The dataset contains stocks of some of the highest quality and most profitable companies, as defined by criteria such as an S&P quality ranking in the “A” category, 25 years of uninterrupted dividends, and at least five dividend increases over the last dozen years.

Currently, for example, out of more than 7,000 publicly traded stocks in the U.S., just 254 make it into this dataset.

Wright classifies each of the stocks that make the grade into four categories according to how its current dividend yield compares to the historical range of that stock’s yield.

The “Undervalued” category contains those stocks with yields at or close to the high end of their respective ranges, while the “Overvalued” category contains stocks with relatively low yields.

The statistic that is most relevant to market timers, I found upon analyzing the data, is the percentage of stocks that make it into this “Overvalued” category. At the 95% confidence level that statisticians often use to determine if a correlation is genuine, this Overvalued percentage is inversely related to the stock market’s return over the next several years.

That is, a high percentage of Overvalued stocks is a bad omen, while a low percentage is a good one.

Currently, Wright’s Overvalued category contains just 35 of the 254 stocks in his dataset, or 13.8% of the total.

That is well below the five-decade average of 21%. In fact, it is lower than 69% of comparable readings back to the mid 1960s.

The current Overvalued Percentage is also a lot lower than what prevailed at prior major market tops. In the months leading up to the bursting of the Internet bubble in early 2000, for example, the percentage of stocks in the Overvalued category rose to near 60% — four times the current level.

And in the weeks leading up to the stock market top in October 2007, the percentage of Overvalued stocks rose to 38%, or three times the current level.

To be sure, even though the current Overvalued percentage of 13.8% is below average, it is still above the lows set in mid-1982 and late 1974/early 1975. On those occasions, according to Wright, the Overvalued percentage fell to around 1%.

So by no means should we get carried away and conclude that the stock market is as undervalued today as it was on those prior occasions — both of which represented historic buying opportunities.
So the future isn’t that bright.

Nevertheless, especially in light of recent market turmoil, it is good to know that the gravitational pull exerted by this long-term dataset is towards higher rather than lower prices.

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