I say so for a simple reason: valuations on The Alternative Investment Market (Aim) stocks have in the past predicted returns on the All-Share index. Since May 1997 (when data began) the correlation between the dividend yield on the Aim index and total returns on the All-Share index in the following 12 months has been 0.42. This is almost as high as the correlation between those returns and the All-Share's yield itself, which has been 0.48. For example, low Aim yields in 2000, 2007 and 2010 all led to falls in the All-Share index while higher yields in 1998, early 2009, 2012 and early 2016 all led to good returns on main market stocks.
What's more, Aim yields predict All-Share returns even if we control for the All-Share yield. To put this another way, Aim yields contain information about future All-Share returns that are not embodied by valuations on the All-Share index. In fact, the regression equation implies that Aim yields matter as much for subsequent All-Share returns as the All-Share yield does.
There's a simple reason for this. Because Aim stocks are usually hard to value accurately, they are driven up and down by waves of sentiment - more so even than most other shares. Higher Aim prices, and lower yields, are therefore a measure of high investor sentiment. Because sentiment tends to mean-revert, high sentiment tends to lead to falling share prices generally, as investors sober up having been in high spirits.
Is this a danger for shares right now?
Simple statistics would suggest not. The yield on the Aim index is above its post-1997 average - as for that matter is the yield on the All-Share. Both point to above-average returns on the All-Share in the next 12 months.
I fear, however, that such an inference might be too simple. We know that Aim stocks have been over-priced for most of the past 20 years, because they've fallen on average during this time. This tells us that, for most of this time, yields on Aim stocks have been too low. Investors should by now have wised up to this fact and so should require higher yields now.
To put this another way, the fact that Aim's yield, at 1.6 per cent, is above its historic average might tell us not that investor sentiment is still depressed, but rather that Aim stocks have adjusted to lower and more realistic valuations. If this is the case, then sentiment might not increase much further and so there’s more risk of the All-Share index falling than historic data would suggest.
Granted, this isn't a screaming sell signal. But it is cause for concern, and will become a bigger one if Aim stocks continue to rise. We must remember that share prices are driven not by reality alone but also by sentiment.
