Is the Rule of 20 accurate?
ImagSource: William Corley
The Rule of 20 (R20) has forecasted the average fair market value for the S&P 500 to be 17.5x its operating earnings since 1988 (illustrated by the yellow dashed line). The R20 is a smart way to tabulate the stock market’s valuation based on its price/earnings (P/E) ratio and inflation rate (CPI). I learned about the R20 from the Maven of Manhattan, Sam Stovall, some years back. R20’s formula has been around for over a half-century, and yet, it is still unfamiliar to many investors. The only calendar years the P/E ratio for the S&P 500 traded below its average and stocks generated negative total returns were 1990 and 2018. In 1990, the index lost 3.06%; the next year stocks were up 26.31%. Last year, the S&P lost 4.23%. How will stocks respond this year?
The R20 equation goes as follows:
Add the S&P 500’s current P/E ratio (16.5) plus the CPI’s growth rate (1.9%), and it equals 18.4. If the total is less than 20, the market may be undervalued by the percentage difference. In this case 20-18.4=1.6. Take the 1.6 difference and divide it by 20; 1.6÷20=.08, or 8%. According to the R20, the market is trading at an 8% discount based on its past 30-year history. Continuing with this line of reasoning, whenever the sum of the P/E + CPI is greater than 20, stocks are considered overpriced by the percentage difference. If the P/E + CPI adds up to exactly 20, the market is considered to be at fair value.
As an example, there have been three bear markets (>20% losses), over these 30 years. The stock market has suffered through two mega-bears stemming from the 2000 tech bubble and the 2008 financial crisis, sending equities lower by 49%, and 57% respectively. Operating earnings P/E ratios fluctuated between 14x on the low side, and 30x on the high side.
During the 2000 internet craze, the S&P 500 traded 30x profits; according to the R20, stocks should have been valued at 17.3x profits. Hence, the S&P 500 was 70 percent overvalued. When the bubble finally burst, leading technology issues watched 80% of their value vanish over the next 30 months. In 2008, this scene played out once more as real estate prices tumbled 40% from excessive leverage and profligate lending; stocks responded by dropping nearly 60%. The carnage left tens of millions without jobs, and others penniless. In June of 2009, the Great Recession ended. By early 2010, job growth and economic expansion resumed. The S&P 500 operating P/E dropped to 15x earnings; R20 suggested fair market adjusted for inflation to be 19x. Accordingly, R20 measured stocks to be 21% undervalued. Twenty-four months after the recession ended, shares recouped 91% of their prior losses.