When is the best time to invest in Alternative Investment Market (Aim) stocks? Given that Aim is at the same level it was 20 years ago while the All-Share has risen 80 per cent, it’s tempting to say: never. Such a reply is, however, too hasty. Aim does sometimes outperform mainline stocks and – better still – such outperformance is partly predictable.
To establish this, I simply looked for indicators that have in the past predicted annual changes in Aim relative to the All-Share index. Just four such indicators can explain two-thirds of the variation in Aim’s annual returns relative to the All-Share index since 2002. And as my chart shows they did a decent job of predicting big outperformance in 2004, 2010 and 2016 and big underperformance in 2008-09 and 2013. The four indicators are:
1.The dividend yield on the FTSE 350 low-yield index. When growth stocks are highly priced, Aim underperforms in the following 12 months. Low yields on growth/speculative stocks are a sign that sentiment towards them is high, and this leads to Aim doing badly as sentiment reverts to more realistic levels. Conversely, high yields are a sign that sentiment towards speculative stocks is depressed, which predicts high returns on Aim shares as sentiment subsequently recovers.
2. The yield curve. When 10-year gilt yields are high relative to three-month rates, Aim tends to do well in the following 12 months. I suspect this is because the yield curve predicts economic activity; a steep curve (with 10-year yields high relative to three-month rates) leads to stronger growth. And faster growth encourages investors to buy riskier assets such as Aim stocks. It was the inverted yield curve in 2007 that correctly predicted Aim’s underperformance in 2008.
3. Oil prices. High oil prices lead to Aim doing badly. Again, this could be because high prices predict weaker economic growth and reduced appetite for risk – a tendency that isn’t fully and immediately priced into shares. This is consistent with a finding by Ben Jacobsen of TIAS Business School and colleagues – that changes in oil prices predict changes in equity prices.
4. The yield on the FTSE 250. When this is high, Aim subsequently does well. This might be because high yields on cyclical mid-caps are a sign that investors are pessimistic about near-term growth. As that pessimism dissipates, so riskier assets such as Aim stocks do well.
There are many indicators that when added to these four don’t improve the ability to predict Aim’s returns. Most surprisingly, these include the yield on the Aim index itself. They also include: the Vix index, the Aim index relative to its 10-month moving average, index-linked gilt yields and the All-Share’s dividend yield.
Now, I stress that what I’m doing here is blind statistics: I’ve just thrown a lot of data at historic returns and seen what’s predicted them in the past. Fans of Columbia University’s Andrew Gelman might be horrified by this as it’s the sort of data-mining he warns us against.
I’ll defend myself. For one thing, there’s nothing wrong with collecting facts. A lot of economic journalism consists of too much opinion and too little data. Secondly, Professor Gelman’s strictures apply to experiments whose results often can’t be replicated and that have little validity outside the laboratory. But this isn’t relevant in this case. It’s surely worth knowing that there has in the past been a good correlation between, say, oil prices or yields on growth stocks and subsequent returns on Aim stocks. Of course, this might not be true in future. But in the social sciences perhaps no evidence can give us certain knowledge of the future.
Thirdly, data-mining is a bad thing when it is used to support one’s prejudices: when you cherry-pick facts to support your prior beliefs. In my case, however, the opposite is the case. This exercise undermines one of my prejudices.
For a long time, I’ve thought that Aim stocks have been systematically overpriced because investors have been irrational; they’ve paid too much for the small chance of great returns.
This belief, however, isn’t supported by these data. If we plug post-2002 average data into my model, we are left with only very slight underperformance by Aim – of less than a percentage point per year. This tells us that Aim’s long-run poor performance has not, for the most part, been due to Aim-specific mispricing. Instead, it’s been because the environment has been hostile to Aim: oil prices have been high and valuations on growth stocks excessive. Controlling for these, Aim hasn’t done terribly badly.
In this light, my conclusion shouldn’t perhaps surprise you. It’s that these factors now predict that Aim will probably outperform the All-Share index over the next 12 months. If past relationships continue to hold, Aim should outperform by almost 10 per cent. To put it less precisely but more accurately, they point to around a five-in-six chance of Aim outperforming. This is because short-term interest rates and oil prices are below their long-term average and yields on growth stocks slightly above average.
Of course, there’s a caveat here: past relationships might not continue to hold. There’s no way of telling one way or the other.
And of course nobody invests in the Aim index itself, but rather in individual constituents that behave very differently from the index. I suspect, though, that my inference holds – that Aim investors might well be fishing in richer waters today than they have in the past.
