We all know that trying to forecast the future is largely a mug’s game, but that doesn’t stop us from trying. More particularly, we tend to focus on small signals which might give us a clue about what might happen next to our portfolios.

These small clues allow us to nudge up or down our risk levels as we anticipate the next Big One: the much anticipated stock market correction. We are all collectively looking for the financial version of the Last Bell, that loud, late-night reminder that the tremendous stock market party of the last few years is well and truly over. We all know that moment of dark fear is coming, it’s just we don’t when. Thus, signals provide us with the clues which help inform our decision making.

The problem, of course, is that these signals are notoriously unreliable and prone to false alerts. Even more pertinently they also tend to fade in usefulness as a result of too much conscious attention by millions of nervous market participants.

At this point I’m often reminded of what the US numbers man Nate Silver once said about signals – he suggested that distinguishing the signal from the noise requires both scientific knowledge and self-knowledge. We need to look for evidence that backs up the signal but also recognise that these signals pander to our baser behavioural biases, i.e. we look for the answers that confirm our hidden biases.

Two signals, two directions

Value investors, for instance, always look to valuation metrics such as the backward-looking price to earnings ratio. The most widely followed aggregate measure is something called Shiller’s cyclically adjusted price-earnings ratio, or Cape, which smooths out equity valuations over business cycles of many years. You can find it online here.

This has been flashing red for many years and is now suggesting that the US market is trading at a vertigo-inducing 30 times long-term average earnings. Yikes!

But the truth of the matter is that the Cape has about as much predictive power in the short term (a year or so) as a chocolate teapot. If you are a value fiend – and I am not far off being one – Cape will confirm your worst fears but don’t bother using it as a signal about what might happen next week, next month or even next year in the markets.

More growth orientated investors love to ignore all the guff about valuations and look at signals that point to earnings growth. The featured signal here looks at earnings beats i.e. the number of times reporting businesses in the S&P 500 ‘beat’ their estimates with real earnings growth.

We are currently a few weeks into the latest quarterly reporting season and overall most US companies have managed to beat the numbers analysts predicted. Hurrah, let the bull market continue!

Except that as a recent note by DWS reminds us, there’s nothing remotely unusual about that amazing revelation. They’ve looked at data going back to 1986 and found that more than half of US companies always surprise the markets. The system is, frankly, gamed.

As a result, over the past three years, 73% of US companies have on average exceeded their forecasts. In essence, US companies have become incredibly good at expectations management and ‘guide analysts down just ahead of quarterly reporting’.

Fear and momentum guides

Looking more broadly afield, some investors rather bizarrely love to focus on measures which track stock market volatility, usually through something called the VIX. As a rough guide, any measure for this US index above 20 elicits frowns, anything above 30 real anxiety while anything above 40 usually results in catatonic terror.

The VIX is thus called the fear gauge, except that this has already fallen victim to the Heisenberg principle which, very roughly, states that the very act of observation can sometimes make a phenomenon (or signal) vanish from view. VIX is now tracked to kingdom come by spread betting and leveraged index products and as a result there’s strong evidence that it’s being corrupted as a signal by its own success.

Also, remember that investing in any product linked to the VIX will almost certainly result in utter wealth destruction if you sit tight for more than a few weeks in a product – market volatility and carry will steadily eat into returns until you’ve nothing left. VIX products are for day traders and speculators only.

Last, but by no means least we’re left with a set of measures based around sentiment which are, in effect, a derivative of volatility – momentum. Volatility measures look at how long momentum trades – bull rallies for example – suddenly unwind in a spasm of market turbulence. The signal within the noise we’re looking for here is that of overenthusiasm and rampant investor bullishness or, vice versa, capitulation.

My own favourite contrarian measure

This comes from a US private investor organisation called the American Association of Individual Investors, or AAII. Consider joining, as its online resources, especially around screening for stocks, are second to none.

It runs frequent sentiment surveys which I find compelling reading – in a contrarian way. In my experience, if you are looking for a useful short-term measure, take a position which is the exact opposite of the current AAII consensus. 

As it currently stands – you can see the numbers here – investor optimism has rebounded from ‘an unusually low level but remains below average’. Crucially, in a more detailed survey looking at responses to the recent market volatility, 37% of respondents said they were long-term or buy-and-hold investors while 36% said they had sold stocks. On this basis I’d suggest a short term bullish, long term bearish attitude.

In particular, it’s entirely possible that we are due a bullish bounce back over the next few months and that we could optimistically target 3,000 for the S&P 500 within the next six months. Cue the legendary ‘melt up’, a last hurrah of bullish optimism before The Big One comes along and gate-crashes the party.