U.S. Equities and the “Rule of 20″

By Walter Kurtz, Sober Look

Numerous analysts – often the same ones that were bearish just six months ago – continue to talk up US equities using a variety of metrics. These include comparisons of dividend yields or PE ratios to treasuries, etc. One of the more unusual metrics is the so-called Rule of 20. Developed over 30 years ago by Jim Moltz, the rule states that for equities to be “fairly” valued , the average PE ratio plus the inflation rate has to be around 20.

With the current PE ratios, the Rule of 20 metric now clocks at around 17 (PE=15, Inflation =2). That means to be valued “fairly” on a historical basis, US stocks’ PE ratio should be around 18, allowing quite a bit of room for multiple expansion. That’s assuming of course that inflation stays subdued. Also Mr. Moltz likely didn’t contemplate deflation risk when designing this rule.

Historically the Rule of 20 performed well in 2000 by pointing how overvalued the market was prior to the correction, and then again in 2007.

According to ISI, the current situation is more akin to 1983, when we were still living in the shadow of the “Death of Equities” and the Rule of 20 metric was at the lows. This “death” was proclaimed in 1979 on the cover of Business Week, which read “How inflation is destroying the stock market”. Of course by 1983, after Volcker had raised the Fed Funds rate to 20% in 1981 (hard to believe, right?), inflation rate had receded. The “anti-equities” mentality however still persisted, creating an opportunity. Since then, the S&P500 increased more than 10-fold (particularly if dividends are taken into account). The Rule of 20 therefore paints an incredibly bullish picture for the US stock market over the next couple of decades. Will Mr. Moltz be proven right again?

Rule of 20

Source: The ISI Group

 

 

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Sober Look

Sober Look

Sober Look was founded by Walter Kurtz, a New York based hedge fund manager and credit markets specialist.

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Comments

  1. In the mid-to-late 1970’s this Rule of 20 was much lower than 20 which is a bullish signal. However, investors had to wait until Aug 1982 before equities really took off. There are other times when historically this was not the greatest indicator. Just one of many indicators out there, and probably far from the best one.

  2. I saw Gina Adams on Bloomberg TV this morning. Gina Martin Adams of Wells Fargo Securities (WFC) has the lowest S&P 500 target of the strategists Bloomberg tracks: 1390, which is 15 percent below where the index now trades. “Overall,” she wrote on May 6, “the number of S&P 500 companies surprising on the upside this season has been low. The index is tracking a beat rate of only 57 percent versus the long-term average of 65 percent. Sales were notably weaker this season. ” She is one of the few strategists who is not hyping and selling this market, but giving a more realistic assessment, a sober look if you will.

  3. Numerology is difficult in these days of distorted fundamentals. One question that comes from looking at the chart, though, is whether there may be the chance that valuations will have to undershoot in proportion to how much the overshot previously.
    In plain terms, nothing says that stocks cannot get “more attractive” valuations still.

  4. Per the chart, there are plenty of instances where this measure fell below 20 and continued to decline, and rose above 20 and continued to ascend. Anticipating turns might be valuable (stock prices as well as this gauge might shed light on this premise); but based solely on the chart, knowing whether you are above or below some arbitrary, static level does not appear to have been very informative.

  5. That’s the most stupid and pointless thing I’ve read all week.

    It really highlights where the market is placed right now when so many analysts are scraping the bottom of various barrels trying to find reasons to be optimistic. “Rule of 20?” Never heard of that one. Certainly didn’t hear of it (or any of these other metrics) when the market was below 1400. Why is that?

  6. i wonder what the current inflation rate would be if the gov used the same calculation method as they did in the 1980’s.

  7. Oh brother. Rule of 20?…how about the rule of “take your freakin’ profits and let the market and this ridiculous floating QE turd swirl on down the drain where it belongs.” This whole market is like some never ending Onion article.

  8. 1983 PE was about 7. But the “20 rule” adds the PE plus inflation to make 20, and it could well be that 1983 inflation was around 13%.

  9. Earnings contain a transitory portion that is due to cyclicality. The countercyclical tendency to have high P/E (due to lower earnings) at the bottom of the cycle and low P/E do to high earnings at the top of the cycle is know as Molodovsky effect.