In this article, I will explore which stock fund categories appear most promising on a short-term basis, and also, which if any, appear to be the best opportunities looking out over the next several years.

Back in Aug. 2008, I developed a tool for determining which categories of funds appear the most attractive, and which the least, based on historical performance trends. These trends show that with apparent regularity, certain fund categories have either done so well as to eventually prompt investors to sell them to protect profits usually as the economy shifts gears, or so poorly that investors have "rotated" into them as they seek out those areas that appear undervalued. Since its development, the tool has been quite successful in that its BUY, HOLD, and SELL readings would have helped investors anticipate which categories were relatively more likely to be the best places to invest over the following several years.

As just one example of the tool's successes, back on Jan. 30 2009, while we were still deeply immersed in a gut-wrenching bear market, its analysis revealed that the Small Growth category was the most attractive of all the 10 major fund categories and the only one that we considered a BUY on that particular date. Also, surprisingly in light of how badly the market was still performing, the remaining 9 categories were at the time shown to be HOLDs. We issued one of our rare "Alerts" to our subscribers to this effect.

Suppose one had acted on the Alert and purchased a Small Growth fund on the next trading date (Feb. 2, 2009) such as the Vanguard Small Cap Growth Index fund (VISGX) (or the comparable ETF, VBK). The closing fund price on that date was 11.08; the price today (8/30) is 30.27, or approaching a three-fold increase. This has proven to be a better gain than shown by any of the remaining recommended 9 HOLD category fund averages, which also wound up doing well since that day. While all 10 recommendations would have served investors well, the odds of singling out the one best performing category over 4 1/2 years later merely by chance would have been just one of out 10.

While our projected recommendations for these same 10 broad categories of funds today may not suggest any clear cut winner, our current readings can still be analyzed in terms of which categories might be relatively better for investors. And, when we analyze additional, more specialized categories of funds, namely sector funds and specific types of international funds, the results more clearly show that certain categories are potentially poised to do significantly better than others. Here then is what our analysis finds:

Small/Mid-Cap Funds

The good news is that, as a whole, all the subcategories of funds in this group still seem to be strong HOLDs as of this writing except Mid-Cap Blend which is a borderline BUY. The categories are listed below in order of potential for positive returns but in most cases, the differences in expected relative returns are small. (All category recommendations in this Newsletter are as of Aug. 29.)

• Mid-Cap Blend

• Small Blend

• Mid-Cap Value

• Small Value

• Small Growth

• Mid-Cap Growth

• The Bad News

The bad news, though, is that over the next several months, in fact as soon as early Oct., it is highly likely that these funds will meet the return characteristics we have previously found are associated with being overvalued. Why? Specifically, I have found historically that average annualized returns of 15% or more, or 75% cumulatively, over the prior 5 years, is highly suggestive of approaching a danger point. In the past, upon reaching that level, returns have usually suffered significantly subpar performance, although not necessarily immediately. Primarily for investors who wish to avoid periods of potential subpar performance which may last for several years, at such lofty levels, my tool will "automatically" rate the category as a SELL.

To cite an example of what can be called the 15% SELL rule, look back to the beginning of the 4th Quarter 2009 when the average fund/ETF that invests in Emerging Markets was at this level vs. virtually all other fund categories which the tool at that time designated as HOLDs. Consistent with the above expectation of poor future performance, over the following nearly 4 years, Vanguard Emerging Markets ETF (VWO) went from 38.36 in price to 37.41, that is, showed a cumulative negative 2.5% return. In comparison, the S&P 500, as a proxy for the US stock market, gained about 55% over the same period while the Vanguard FTSE Developed Markets ETF (VEA), a proxy for foreign stocks without emerging markets, gained about 8.5%. (These results do not include dividends.)

Large Cap Funds

The 3 subcategories of funds under this heading are listed in order of the tool's projections for positive return potential.

• Large Value is now a strong HOLD.

• Large Blend is now a moderate HOLD.

• Large Growth is also a moderate HOLD.

Once again, though, there is potential bad news ahead: By early to mid-Oct. these categories will also likely exceed a 15% annualized return over the prior 5 years suggesting overvaluation at that point.

More Bad News

Even if all of the above categories/subcategories mentioned thus far suffer a 10% to 20% correction from their 8-29 prices, they would still not have "corrected" enough to prevent becoming what we consider overvalued.

Foreign Funds

The overall category is now a borderline BUY. Looking at one representative fund, the Vanguard Total International Stock Index (VGTSX), the current price is about 1% annualized lower than it was 5 years ago. Unfortunately, it too likely will become overvalued, but not as soon as the above funds, perhaps by mid- to late November this year.

Specific types of foreign funds now have differing outlooks and are listed in order of positive potential:

• Europe is considered a BUY.

• Japan is also considered a BUY.

• Emerging Markets are a weak HOLD.

• Diversified Pacific/Asia is also a weak HOLD.

Unlike the U.S. fund categories above, all these overvaluations, while serious, could be ameliorated by a correction of perhaps just a little greater than 10%.

Sector Funds

For investors who are willing to invest in less broadly diversified areas of the market through the use of sector funds/ETFs, my tool's analysis suggests that there are a few more categories that may have quite positive outlooks right now. The sectors are listed below in order of potential for positive returns as shown by the tool right now:

• Energy (BUY)

• Commodities (BUY)

• Financial (BUY)

• Industrials (strong HOLD)

• Health (strong HOLD)

• Natural Resources (moderate HOLD)

• Consumer Cyclical (also referred to as Consumer Discretionary) (moderate HOLD)

• Communications (moderate HOLD)

• Technology (moderate HOLD)

• Consumer Defensive (also referred to as Consumer Staples) (moderate HOLD)

• Global Real Estate (weak HOLD)

• Utilities (weak HOLD)

• Precious Metals (weak HOLD)

• Real Estate (US) (weak HOLD)

But just as for the non-sector categories above, most of the sector funds will likely approach overvaluation within the next few months. The exceptions are Commodities and Precious Metals. This means that while investors may have to suffer through possible extended corrections in price even for funds currently rated as BUYs, holders of the average Commodities and Precious Metals fund will likely not see their fund reach overvaluation.

Understanding Why the Data Suggest a Change of Direction

The above analysis suggests a potential dilemma for investors who would like to follow the tool's recommendations. On the one hand, most major categories of stock funds, as well as sector funds, are still currently seen as worthy of HOLDing, and a few are even considered as BUYs. On the other hand, all of the categories listed above, except two (Commodities and Precious Metals) appear close to automatically alerting investors that selling or reducing one's position in the category may be wise. Why, then, the apparent contradiction?

The dilemma springs from the fact that the closer we get to the five-year anniversary of the huge price drops that began around the beginning of Oct. 2008, at the peak of the financial crisis, the more investors (as well as my tool) must evaluate data showing the extent of gains that have been achieved since those lows. This, combined with the likely announcement of a gradual rollback (or "tapering") in support for the markets coming out of the Fed, means that most stock fund categories may experience a period of disappointing, or worse, quite negative performance.

It was almost five years ago that the stock market was about to embark on a hair-raising free-fall. As you are likely aware, less than 6 months after that Oct. '08 date, in early March '09, the stock market's performance did an abrupt U-turn. Specifically, on 8-29-08, the S&P 500 index closed at 1,283. Today (9-2), it's at 1,633 When taking into account just last 5 years then, the total gain has been merely about 27%, or 5.5% annualized. With dividends added in, this amounts about 7.5% annually. This is historically a somewhat below average return and does not suggest stock investors have been excessively overbuying into the current bull market when considering the magnitude of the drop, which actually began in Oct. 2007.

However, just about 1 1/2 mo. later, in mid-Oct. '08, as the financial crisis boiled over, the S&P 500 index sank down to close at 908 and continued on its way down. Assuming the S&P remains near its current level of 1638, this means that the total gain over that 5 year period (mid-Oct '08 - mid-Oct. '13), will have been about 80%, or 16.1% annualized. With dividends added in, this is about 18% annualized. Even more troubling, the gains will likely be even more astronomical as we head into 2014 as a result of lower and lower starting points for five year returns that were recorded until early Mar. 2009 when a low of 667 was reached. Again, assuming the S&P 500 at today's 1638, the total 5 year gain (Mar. '09 - Mar. '14) becomes 146% or about 31% annualized with dividends.

As you can see, by mid-Oct. of this year, investors will likely have pushed the index's gains to approximately double the 9 to 10% annualized return expected over a five year period, and three times the expected return by a few months later. Without an upcoming significant correction, or worse, a bear market, investors will appear to have pushed most stock categories' performance way ahead of themselves. This is why it appears to me that in the next month or two, and even more so within the next six months or so, stocks could be highly vulnerable to a drop back to a more normal level of returns.

This might mean, for example, that one might theoretically expect a drop in the S&P 500 index back to the 1300s, or in a worst case scenario, to around 1000. This would return the average five year gain to about 10% a year vs. the 18% or even 31% a year gains just cited. And at worst, such would represent a drop of about 40% from its current level which would certainly qualify as an eye-opening bear market. And the drop back to more normal 10% annual returns could be even greater if the index rises even more over the next month and a half.

Of course, I readily acknowledge this scenario may not play out as outlined above. It is based on one overriding assumption which is built into the tool I devised for judging whether stocks and stock funds are overvalued, undervalued, or relatively typical compared to prior returns. This assumption's validity can never be known with certainty for any given future period:

Assumption: The future trajectory of long-term stock fund/ETF prices will play out with close resemblance to how they have consistently acted in the past.

My research suggests, but does not guarantee, that large stock gains in any category of funds averaging 15% or more a year over 5 years will tend to be followed by a return over a full 10 year period to more average levels (i.e. 9-10%). This theoretically means that over the next 5 years, S&P 500 returns are likely not to be good at all, perhaps at best in the range of 2 to 5% per year. And it appears that small and mid-cap returns will be even worse. Such a shift from excellent performance to relatively poorer performance may not start immediately; rather, my data suggests it is most likely to start within approximately a year or so of reaching this 15% level.

Of course, all diligently made investment forecasts are based on one or more assumptions, some clearly stated, while many not. If one does not place much stock in my above assumption, an assumption I developed from studying the behavior of prior fund category performances over several decades, it would likely make sense not to choose to follow its recommendations. In other words, therefore, one can readily dismiss these forecasts if one believes that every stock fund cycle is different and that what lies ahead may differ from the norm of prior cycles.

In fact, as measured back in late 1999, most fund returns were able to move ahead more than another 20%+ over the following year in spite of averaging 15% or more a year over the prior 5 years. But, over the following 4 years, most category returns plunged sharply.

Even if one rejects the timeframe suggested by my research, it would be hard to argue that stocks will continue to average a gain of 18% (or more) a year indefinitely. Stocks are likely, it would seem, to return to their prior 10% returns sooner or later. This would appear to suggest at best only small average gains over the following 5 years for most categories, to return the 10 year average back closer to 10%.

If the Overall Market Is Near a Dangerous Level, What To Do?

So what should an investor do, if anything? The answer isn't obvious as it depends on the way in which you choose to manage your portfolio.

• If you plan to hold most of your funds for five years or longer, and can stick to that plan in spite of potentially big drops ahead, you may actually choose not to do anything. Why? If a big drop occurs in the market some time over the next year or so, this could be enough to clear out many of the excesses that I anticipate will have developed. Once the excesses are removed, the market may be able to continue to perform in line with its historical averages, and perhaps still surpass the returns available from bonds or cash over the full 5 year period.

• Other investors may choose to use the above forecasts to exchange one's existing stock investments into the fund categories the tool ranks more highly, or, when rebalancing, to shift out of the lower ranked categories within their portfolios in order to potentially minimize losses.

• Finally, some investors might want to seriously consider selling from most categories, especially after seeing a confirmation that the tool I devised has indeed started to issue SELL signals; as suggested above, this might be expected to happen as early as this October. But, as I have just said, such moves might not be warranted for long-term investors. Rather, such selling makes most sense either for conservative investors who cannot tolerate serious losses, or for investors who are willing to risk both exiting out of and back into the market when conditions seem appropriate, hoping to get the timing right at both junctures. Even long-term investors, while not wanting to completely sell out of a category, might consider reducing their position in that category. Given that, it makes sense to regard what we have thus far been referring to a SELL signal as one that rather just suggests that investors REDUCE a position.

For readers interested in just how well the tool has done in predicting the performance of 25 different categories of funds over the last three years, you can go to my website and see the Sept. 2013 Newsletter.