Will Stocks Sink From Here?

Chip Corley  |

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.



DISCLOSURE: DISCLOSURE: The opinions made herein are for informational purposes and are not recommendations to any person to buy or sell any securities. The information is purported to be reliable, but its accuracy and completeness are not guaranteed. 1st Discount Brokerage does not accept any liability for the use of this column. Readers of this column who buy or sell securities based on the information in this column are solely responsible for their actions. Investors/traders are advised to satisfy themselves before making any investment. Nothing published on this site/ article should be considered as investment advice. It's not an offer to buy or sell any security. Readers are solely responsible for their profits or losses.


The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Comments


Watchlist

Symbol Last Price Change % Change
AAPL

     
AMZN

     
HD

     
JPM

     
IBM

     
BA

     
WMT

     
DIS

     
XOM

     

World Economic Forum at Davos 2019 - Kitty Parry CEO DeepView

Matt Bird sits down with Kitty Parry, CEO DeepView, at the World Economic Forum at Davos 2019

Emerging Growth

Viking Energy Group Inc

Viking Energy Group Inc is the United States based independent exploration and production company. The company is engaged in the acquisition, exploration, development, and production of oil and natural gas…