May 9, 2022 (S&P 500 @ 4100)
This post explains why the Rule of 20 is clearly the superior valuation tool for the U.S. equity market.
In March 2009, I got involved into the then raging debate on equity valuation publishing S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years (https://www.edgeandodds.com/smart-investing/sp-500-p-e-ratio-at-troughs-a-detailed-analysis-of-the-past-80-years/). I showed that the conventional absolute P/E 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).
The S&P 500 index was then selling at 12-13x trailing normalized EPS but equities had sold as low as 7x in 1980.
I explained, backed with 80 years of history, that, actually, equity valuations were then at a true historical low with the Rule of 20 P/E at 13.5, and that, barring deflation, equities were at or near their lows and could advance 20-40% during 2009 with little downside risk.
Between 2010 and 2021, core inflation was very stable around 2.0% and investors naturally dismissed inflation as a variable they should not be concerned with.
Core CPI inflation reached a pandemic low of 1.4% in Q1’21. The S&P 500 P/E peaked at 27.8 in March 2021 when the Rule of 20 P/E reached 29.1, indicating a 31% downside risk to the “20” fair value.
The Rule of 20 simply states that fair P/E is 20 minus inflation with the sum of P/E and inflation (the R20 P/E) generally fluctuating between 15 and 25. At 20, valuation upside of 25% equals valuation downside.
The chart below plots the S&P 500 Index actual P/E ratio (red, right axis) against the Rule of 20 ratio (blue, left axis). The median line is shared as 20 for the Rule of 20 and 15 for the conventional P/E so that deviation around the median is visually similar.
- The R20 P/E fluctuates within a generally consistent range of 15-25 while the conventional P/E range is very erratic. This is what inflation does.
- During periods of high inflation (e.g. 1974-1985), P/Es decline and can stay low enough to give a constant sense of “reasonable value” to equities. The R20 warning in late 1980 proved quite useful preventing a 24% drawdown even when P/Es were below 10. How could you assume in mid-1982 that a 7 P/E was low enough when the same P/E led to a disaster 18 months before? The Rule of 20 P/E was at a generational low of 15 in mid-1982, giving investors a clear, unambiguous signal that led to a 3-bagger over the next 5 years.
- When inflation is more subdued, signals from the R20 P/E are much clearer than those given by the conventional P/E like in the 1960s and the mid-1990s. During the 1960’s, the conventional P/E was in overvalued territory most of the decade while the Rule of 20 gave 2 very profitable buy signals (1962 for a 69% gain and 1966 for a 40% gain).
- In early 2009, a conventional P/E of 12 proved low enough, even though it was well above levels seen in the 1975-1984 period. The Rule of 20 was totally clear, not only in 2009 but right up to early 2016 for another tripling in equity values.
- A conventional P/E of 14.6 in December 2018 and 14.0 in March 2020 may not have been appealing enough given the circumstances but the R20 P/E was again clearly in buy-low range in both instances.
It is no surprise that when inflation is either very low or very high that the conventional P/E fails to provide equity investors with the better signals provided by the Rule of 20.
The former, a single number, 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 P/E ratio. When inflation rises, interest rates also normally rise to keep real rates within an appropriate range. P/E ratios need to decline to reflect the increase in the earnings discount rate.
Another way to look at it is that, as interest rates rise, 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 large percentage of earnings comes 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 (though 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 conventional P/E makes no adjustment for meaningfully changing economic and monetary conditions. It leaves investors guessing what should be an appropriate multiple between 7 and 22 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 and assess their valuation risk rigorously and objectively.
One hundred years of equity markets valuations through thick and thin and all kinds of economic environments back the legitimacy of the Rule of 20 valuation method.
This next chart, the R20 Barometer, also displays trends in the Rule of 20’s measure of fair value, the level at which the S&P 500 index should trade if at a R20 P/E of 20. The gap between the R20 FV (yellow) and the S&P 500 (blue) is reflected in the R20 P/E (black) vs its 20 fair value. The trend in the R20 FV line is also important to assess whether the under or over valuation will likely be closed by a rising or decreasing level of fair value, either through growth in earnings or inflation or both.
This close up chart shows the huge gap between current equity levels (4100) and the current R20 FV (2900). It also shows the 7% decline in the R20 FV since October as rising inflation, from 4% to 6.4%, has more than offset the 9.5% rise in trailing earnings. A declining fair value puts additional stress on elevated valuations, lowering the floor.
The opposite is just as valid. From 2010 to mid-2015, and again between 2017 and 2019, and again during most of 2021, a rising fair value helped sustain equity valuations even when in overvalued territory.
Valuation risk is presently extreme with fair value 29% below current index values, not allowing for the real possibility that equities sell through the 20 FV line.
Much hope rests on inflation: if core inflation retreats to 4% YoY while trailing 2022 EPS reach $228 (current consensus), fair value would rise to 3650. To justify current valuations, core inflation needs to quickly decline towards the Fed’s target.
Lastly, the Rule of 20 is not a timing tool, merely an objective way of measuring risk vs reward.