THE RULE OF 20: THE HISTORICAL RECORD

The Rule of 20 is simply the best gauge for assessing how attractive equity markets are at any given point in time. It is simple, so simple that nobody pretending to guru fiefdom will even mention it. It is also safe since it involves no forecast, only using trailing earnings and inflation.

The Rule of 20 states that fair value is 20 minus inflation X trailing EPS. Why? Simply because this what it is. The average Rule of 20 P/E since 1965 is 20.0 and the median is 19.8. Since 1957: 19.9 and 19.7. Dispersion along the mean is generally –5 to +5. Pretty consistent, isn’t it? But seemingly much too simple  for most people who, for their own reasons, need to use much more complicated models (see chart below).

Currently, trailing operating EPS are $115.20 on the S&P 500 Index (per Thomson Reuters) and core inflation is 2.2% YoY.

The S&P 500 fair value is thus (20 – 2.2) = 17.8 x 115.20 = 2050.

At its current level of 2185, the S&P 500 Index is thus overvalued by 6.6%.

Historically, the Rule of 20 P/E has generally ranged between 15 and 25, except in periods of deep under or over valuation such as between 1998 and 2002 and in early 2009. The chart below illustrates how stable and practical that range has been over time under various inflation and interest rates, unlike the simple P/E approach plotted below.

The Rule of 20 is not a forecasting tool. Rather, it is an objective measure of the risk/reward equation for equities at any point in time. It states that at 20, equity markets are at equilibrium where the downside risk on valuation (-25% from 20 to 15) is equal to the upside potential (+25% from 20 to 25).

Below 20, the valuation risk gets lower than the upside potential and equities become increasingly attractive from a risk/reward standpoint. The farther below 20, the most attractive equities get almost regardless of the economic and financial environment.

Above 20, the valuation risk increases significantly since valuation swings often carry all the way towards 18 or even 15 in the worst cases. The environment, financial, economic, political or social, becomes very important as high valuations make investors increasingly nervous and prompt to sell and book profits.

Once the valuation risk is assessed, one can concentrate on the dynamics: inflation and profit trends and fluctuations in sentiment.

Here’s The Rule of 20 record so you can appreciate its usefulness:

The smart way to use the Rule of 20 is to gradually increase equity exposure as the Rule of 20 P/E declines towards 15, manage exposure as it rises towards 20, and to aggressively reduce equities as it rises towards 22, being completely out of stocks beyond 22.

Using a simple, although admittedly really unfair, rule of being fully invested at 20 or below and totally disinvested above 20, the return (capital only) since 1950 is +10.7% annually at or below 20 compared with +0.6% above 20. Any investor would do much better by taking full advantage of the gradualism provided by the objective risk/reward calculations offered by the Rule of 20. As mentioned, this approach requires zero forecast since it only uses trailing data.

Here’s more granularity:

Since 1927, at various Rule of 20 P/E ranges, the subsequent 6-month returns gradually decline from +6.5% between 14 and 17.9 to –3.7% above 25.

The 1927-2016 period includes 3 years between 1962 and 1965 when the Rule of 20 hovered closely around the 20 level and equities rose continuously as the earnings and inflation trends were very favourable. These 3 years account for 16% of the data between 19.0 and 20.9 and therefore are somewhat boosting the results in this particular range.

I ran the data since 1966 to exclude the 1962-65 period:

Since nothing is perfect in this world, the 1966-2016 period somewhat overweighs the extraordinary 1998-2002 bubble years, which also distorts the data particularly above 22.

Nonetheless, the record is pretty compelling and useful, even more so when compared with that of a straight P/E strategy:

The Rule of 20 is particularly useful on risk/reward analysis. The following charts provide the probability of losing money over 6 and 12 months at select Rule of 20 P/E ranges during both periods reviewed here (the same caveats mentioned earlier apply):

Investing is not a forecasting game, it is a game of probabilities and risk management. These tables allow us to better appreciate the risk we are each willing to take at any point in time in relation to the potential reward and our own risk tolerance. To illustrate, the current reading is 21.2 on the Rule of 20. History tells us that we have a 40% probability of losing money over the next 6 and 12 months with a potential return of between 0% and 1% (on average). So, unless the earnings and/or inflation environment change for the better, the current risk/reward profile of U.S. equities is not favourable to investors.

One can say that there remains a 60% probability of making money. True, but with a meagre 0-1% historical average return (the median is 3.3%). How lucky do you feel? How unlucky can you afford to be?

This ain’t an easy straightforward game. You must decide whether you want to play it rationally … or simply play and hope for the best which most talking heads and investment advisors understandably recommend. The dealer has a vested interest at keeping you at the table. Rational play requires discipline and patience, “play and hope” luck and strong staying power if you want to stay at that table for a while.

Bearnobull.com, while keeping you up-to-date on the Rule of 20, also provides the straight facts and objective analysis to help us all optimize our decisions.

Other links of The Rule of 20:

• The Rule Of 20 Equity Valuation Method
• Understanding The Rule Of 20 Equity Valuation Barometer
• A Powerful Combo: the Rule of 20 and the “120 Yield Spread”

THE POWERFUL ADD-ON: THE “120 YIELD SPREAD”

This may sound like a laundry detergent ad but the effectiveness of the Rule of 20 has been improved.

In December 2014, a reader alerted me of a post by Eddy Elfenbein which stated that:

When the spread between the 90-day and 10-year Treasury yield is 121 basis points or more, the stock market does much better than when it’s 120 basis points or less.

Digging in, I discovered the very positive impact that the “120 Yield Spread” (120YS) has on the equity risk/reward ratio. The whole story and details are here but here’s the short version.

Combining the reliable valuation proxy provided by the Rule of 20 with the useful economic trend/momentum reading provided by the “120 Yield Spread ” improves the already excellent results from these two proxies.

This idea is supported by the fact that in all 6 instances when the 120YS was not effective, the Rule of 20 was actually flashing the correct reading. Conversely, the Rule of 20 barometer, being a valuation gauge, has occasionally had timing issues that the 120YS would have alleviated.

Interestingly and importantly, the only period when both gauges failed simultaneously was between December 1976 and February 1978 when equities lost nearly 20% while the Rule of 20 P/E was in the “lower risk” 15-16 range and the yield spread averaged 212. Only one miss out of 21 cycles is pretty remarkable.

The complementarity is clear, significant and fundamentally sound. The Rule of 20 valuation analysis provides the fundamental risk/reward equation while the 120 Yield Spread adds the momentum input from the economic and monetary trends. With simple, objective readings, investors can manage their equity exposure on the basis of both value and momentum according to their own individual risk profile.

The 120YS broke below 120 in early July but is now at 123. A sustained break below 120, towards a flat yield curve, would make life difficult for equity markets. All relevant stats are here.