THE “RULE OF 20” EQUITY VALUATION METHOD

In March 2009, I got involved into the raging equity valuation debate by publishing S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years. I showed that the conventional absolute PE ratio approach widely used by the bears to recommend continued selling of equities was inadequate for the circumstances as it failed to take into account the significant decline in inflation rates (and interest rates). I explained, backed with 80 years of history, that equity valuations were then at a true historical low and that barring deflation, equities were at or near their lows and could advance 20-40% during 2009 with little downside risk. Since then, I have continued to successfully use The Rule of 20 to support my equity valuation work. This post explains why it is the superior valuation tool for the US equity market.

The Rule of 20 simply states that fair PE is 20 minus inflation with the total of PE plus inflation generally fluctuating between 15 and 25.

The chart below plots the S&P 5oo Index actual PE ratio (in red on the right axis) against the Rule of 20 ratio (in blue on the left axis). The median line is shared as 20 for The Rule of 20 and 15 for the Actual PE (PE 15) so that deviation around the median is visually similar. Arrows point to market highs and lows. The S&P 500 Index semi-log chart below is for reference.

During the 1960’s, the PE 15 was in the overvalued area most of the decade while the Rule of 20 gave 2 buy signals (1962 for a 69% gain and 1966 for a 40% gain) that the PE 15 failed to signal. In May 1974, the PE 15 gave a strong  buy signal while the Rule of 20 gave but a feeble one that it feebly reversed in mid-1975. The PE 15 failed to give a sell signal at that time. In fact, it remained in the undervalued area between 1974 and 1985 even though the market was unchanged between December 1976 and July 1982.  The Rule of 20 gave a strong buy signal during 1977 and a sell signal in 1980, after the market had gained some 75% and just before it tanked 24%.

The Rule of 20 gave another strong buy signal in mid-1982 (remember, the PE 15 had been flashing BUY since 1974). The PE 15 reached fair value in April 1986, which the Rule of 20 only reached in March 1987 after another 24% appreciation in the S&P 500 Index. Both ratios signaled SELL during 1992 but only the Rule of 20 gave a BUY at the end of 1994 with the PE 15 then only at the fair value level. Both methods moved to overvaluation and extreme overvaluation between 1997 and 2002. The PE 15 remained in overvalued territory until August 2010 when it reached fair value.

Meanwhile, the Rule of 20 ratio reached fair value in September 2002, gave a buy signal in September 2006, started flashing overvaluation in October 2007 and gave a strong sell signal in May 2008. It went to undervaluation in November 2008 and reached what could prove to be a generation low in February 2009. The previous such low for the Rule of 20 was recorded in June 1955.

During the early 1960’s, US inflation hovered around 1.0% for nearly 7 years following violent inflation and disinflation periods after WWII. During the 1970’s through 1982, inflation fluctuated between 3% and 15%. After that and right up to 2008-09, inflation was relatively benign between 3% and 5%. It weakened rapidly in 2008-09 and remains in the 1% range since.

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It is not a coincidence that when inflation is either very low or very high that the PE 15 fails to provide equity investors with the better signals provided by The Rule of 20. The former, being merely a number (15) with “a trading range” around it (from 10 to 20) takes no account of meaningful changes in the inflationary environment, even though inflation has a direct impact on interest rates which directly (but inversely) impacts the discount rate that is the PE ratio. When inflation rises, interest rates also normally rise to maintain real rates within an appropriate range. PE ratios need to decline to reflect the increase in the earnings discount rate. Another way to look at it is that equities then face more competition for money from fixed income instruments. The cost of equities must therefore decline to keep or attract investors.

Furthermore, high inflation rates tend to reduce the quality of earnings through inventory profits for FIFO-accounting companies. If a larger percentage of earnings come from illusory and temporary inventory profits, these earnings should sell at reduced valuations.

Finally and importantly, investors know that rising inflation is generally not tolerated by central banks. An eventual rise in short term interest rates, often followed by an economic slowdown and lower profits, therefore gets factored into equity values when inflation rises.

At the other end of the spectrum, very low inflation rates (but not deflation) generally boost equity valuations. Interest rates then being generally low, investors tend to favor equities, especially when earnings are buoyant. Monetary authorities are often very accommodative in such periods, providing equity investors with an extended positive investment horizon as well as ample liquidity.

The PE 15 approach makes no adjustment for these meaningfully changing economic and monetary conditions. It leaves investors guessing what should be an appropriate multiple between 10 and 20 in spite of what could be very significant and fundamental shifts in the investing environment. The Rule of 20, while not perfect, helps investors adjust to the changing conditions as they happen. Eighty years of experience of equity markets valuation through thick and thin back the legitimacy of the Rule of 20 valuation method.

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