What This Market Indicator Is Telling Us

After staging an impressive rally from its lows a year ago, the stock market appears to have taken a slight breather, as stocks have fallen roughly 6% since mid-January. That's not too surprising, given how far and fast the market has rebounded since its just-as-stunning descent earlier in the financial crisis. But now investors are left wondering where we go from here and are looking for some signposts along the way for guidance.

Mixed reviews
According to a recent MarketWatch article, investors who want a reliable technical market omen might want to take a look at how much cash mutual funds hold in comparison to their total assets. The specific indicator in question in this case is the Fosback Index, so named for creator Norman Fosback. This measure takes the cash-to-assets ratio and adjusts it for the level of current interest rates, since managers are less likely to own interest-earning cash equivalents when rates are low.

Right now, the indicator is stuck in fairly neutral territory -- it's still positive, but has fallen fast in recent months and is much less bullish than it was a year ago. This tepid reading is probably just about right for where we are in the current market cycle. The market has staged an impressive rally since last spring, so valuations are significantly higher, cutting down on the chance of further fundamentals-based appreciation. But given the emerging economic recovery we've seen so far, the market doesn't appear to be in any significant danger. Ned Davis Research has calculated that when the Fosback Index is between 0.75 and 1.13 -- the current reading stands at 1.03 -- the S&P 500 has gained about 2.9% on an annualized basis.

Batten down the hatches
Now I would never recommend that investors manage their portfolios on the basis of technical market indicators like this, but I think the Fosback Index is telling us something important: Don't expect fireworks from the market right now. A hefty run-up like we've had is much more likely to give way to a period of subdued returns. If we look to history, it's not hard to identify examples in which a short period of outsized gains for stocks led to an extended letdown:

Source: Yahoo! Finance. Return figures are for Jan. 1 to Dec. 31, 1999, and Jan. 1, 2000 to Dec. 31, 2007.

I would expect that, at least in the immediate future, stock returns are likely to be rather subdued.

But that doesn't mean investors should abandon equities, because there really aren't a whole lot of other attractive options out there right now. Bond yields are incredibly low, and with the Fed poised to raise interest rates likely sometime late this year, this asset class doesn't have a whole lot of breathing room. Corporate bonds are slightly more attractive than Treasuries, but as a whole, bonds just aren't as well-priced as they were a year or two ago. I'm skeptical about the need for commodities exposure in a portfolio, which leaves stocks as one of the best places to be right now, even if their prospects may be somewhat restrained in the near future.

A marathon, not a sprint
But despite these middling expectations for the market, don't assume that it's all downhill from here. Other market indicators are giving a slightly more positive slant on near-term conditions. Following the recent market drop over the past month, investor sentiment has fallen sharply, with just 29% of investors surveyed by the American Association of Individual Investors saying they were bullish in February compared to 41% in January. Since investor sentiment is a pretty handy contrarian indicator in its own right, that means a short-term bounce could be in the works.

Of course, what the market does in 2010 shouldn't matter too much to long-term investors -- it's what happens over the long run that counts. We can use expected short-term trends as expectation-setting devices without running to adjust our portfolios to try to beat every dip and bounce in the market. If we know that a market correction is likely and that stocks may not produce their best returns this year, it makes it that much easier to hold on and stick to our long-term asset allocation. We should all keep an eye on the long-term picture, but these shorter-term market signposts can still help us in managing expectations along the way.

Investors would be foolish (with a lower-case "f"!) to hang their entire portfolio around what a single market indicator is telling them right now. However, I think there's probably something to what the Fosback Index is indicating. So keep your return expectations in check; brighter days are ahead for the stock market, but it may take us awhile to get there.