Aim shares have held up relatively well this year despite the fall in mainline stocks – so much so that the ratio of the Aim index to FTSE 100 is now close to a seven-year high. This should slightly worry all equity investors, even if they don’t hold many Aim shares.
I say this because high ratios of the Aim index to FTSE 100 have in the past predicted falls in the All-Share index, especially if we control for the long-term downward trend in the ratio. For example, a high ratio of Aim shares to the FTSE 100 in 2000 led to the general market falling, while low ratios in 2003 and 2009 led to rises in shares generally.
This is not to say that the ratio is a perfect predictor: nothing is. The ratio was high in 2004-05 without any subsequent drop in the market, and it sent no warning of the 2008 crash.
Nevertheless, there is some predictability here. Since May 1997 the correlation between the (detrended) Aim-FTSE 100 ratio and subsequent three-year changes in the All-Share index has been minus 0.37. Much the same is true if we look at valuations. When dividend yields on Aim stocks are especially low relative to those on the FTSE 100, the All-Share index subsequently tends, more often than not, to do badly in the following years.
The ratio of Aim shares to the FTSE 100 has, then, some ability to predict changes in the All-Share index. It has even greater ability to predict changes in Aim shares themselves. Since May 1997 the correlation between the ratio and subsequent three-year changes in Aim shares has been minus 0.6. That means over a third of the variation in future Aim returns can be explained simply by current levels of the Aim and FTSE 100 indices.
There’s a good reason why this should be so. Aim shares tend to be younger than other ones, and often less profitable. This means they are even harder to value accurately than other shares which means that their prices are more sensitive than most to changes in investors’ sentiment. When investors are unusually bullish, they’ll drive up Aim shares more than others – as they did at the peak of the tech boom. And when they are bearish, they’ll drive Aim shares down more, as they did in the aftermath of the 2008 crisis.
Sentiment, however, tends to mean-revert especially over longer periods (which is why I’ve referred to three-year changes in prices). Investors do not stay very bearish or bullish for long. This means that when sentiment (and hence the Aim index) is high it is likely to fall. Such falls drag down share prices generally and especially those of sentiment-sensitive stocks such as Aim shares themselves. Conversely, when sentiment is depressed it tends to subsequently recover, which pushes prices up.
With the Aim-FTSE 100 ratio now near a seven-year high, this augurs badly for the All-Share index, and worse for Aim. Post-1997 relationships point to the All-Share index falling slightly over the next three years and Aim falling over 20 per cent.
Worryingly, high Aim prices are not the only indicators that sentiment is still high. Foreign buying of US shares, a still-high ratio of global share prices to the global money stock, and low discounts to net asset values on many general investment trusts all tell us the same story.
Luckily, though, we also have one big reason for optimism. The dividend yield on the All-Share index is well above its 20-year average, at 3.9 per cent compared with 3.2 per cent. This has historically been a far stronger predictor of future returns on the All-Share index than the Aim-FTSE 100 ratio. Whether it is strong enough to offset all the other bearish lead indicators is, however, another matter.
