The Rule of 20 Can Make You Plenty

November 20, 2011 at 3:01 pm 5 comments

There is an endless debate over whether the equity markets are overvalued or undervalued, and at some point the discussion eventually transitions to what the market’s appropriate P/E (Price-Earnings) level should be. There are several standard definitions used for P/Es, but typically a 12-month trailing earnings, 12-month forward earnings (using earnings forecasts), and multi-year average earnings (e.g., Shiller 10-year inflation adjusted P/E – see Foggy P/E Rearview Mirror) are used in the calculations. Don Hays at Hays Advisory (www.haysadvisory.com) provides an excellent 30+ year view of the historical P/E ratio on a forward basis (see chart below).

Blue Line: Forward PE - Red Line: Implied Equilibrium PE (Hays Advisory)

If you listen to Peter Lynch, investor extraordinaire, his “Rule of 20” states a market equilibrium P/E ratio should equal 20 minus the inflation rate. This rule would imply an equilibrium P/E ratio of approximately 18x times earnings when the current 2011 P/E multiple implies a value slightly above 11x times earnings. The bears may claim victory if the earnings denominator collapses, but if earnings, on the contrary, continue coming in better than expected, then the sun might break through the clouds in the form of significant price appreciation.

Just because prices have been chopped in half, doesn’t mean they can’t go lower. From 1966 – 1982 the Dow Jones Industrial index traded at around 800 and P/E multiples contracted to single digits. That rubber band eventually snapped and the index catapulted 17-fold from about 800 to almost 14,000 in 25 years. Even though equities have struggled at the start of this century, a few things have changed from the market lows of 30 years ago. For starters, we have not hit an inflation rate of 13% or a Federal Funds rate of 20% (~3.5% and 0% today, respectively), so we have some headroom before the single digit P/E apocalypse descends upon us.

Fed Model Implies Equity Throttle

Hays Advisory exhibits another key valuation measurement of the equity market (the so-called “Fed Model”), which compares the Treasury yield of the 10-year Note with the earnings yield of stocks  (see chart below).

Blue Line: 10-Yr Treasury - Red Line: Forward PE (Hays Advisory)

Regardless of your perspective, the divergence will eventually take care of it in one of three ways:

1.) Bond prices collapse, and Treasury yields spike up to catch up with equity yields.

2.) Forward earnings collapse (e.g., global recession/depression), and equity yields plummet down to the low Treasury yield levels.

AND/OR

3.) Stock prices catapult higher (lower earnings yield) to converge.

At the end of the day, money goes where it is treated best, and at least today, bonds are expected to  treat investors substantially worse than the unfaithful treatment of Demi Moore by Ashton Kutcher. The Super Committee may not have its act together, and Europe is a mess, but the significant earnings yield of the equity markets are factoring in a great deal of pessimism.

The holidays are rapidly approaching. If for some reason the auspice of gifts is looking scarce, then review the Fed Model and Rule of 20, these techniques may make you plenty.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

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5 Comments Add your own

  • 1. Margaret  |  November 21, 2011 at 10:35 am

    Lynch’s estimate of equilibrium P/E is based on estimated inflation of 2 %. Inflation is much higher when calculated using pre-1994 formulas (which yield a much more accurate measure of inflation) – close to 11%. So equilibrium P/E is closer to 10, very close to current actual P/E of around 11. So it is not surprising that stock prices rise several hundred points and then fall again several hundred.Stock prices are volatile, going up and down around the equilbrium price levels, but they will always move back toward equilibrium.

    Lynch knows inflation is much higher than 2%, or at least he should know.

    Reply
    • 2. sidoxia  |  November 21, 2011 at 11:08 am

      Margaret, the “Rule of Twenty” is based on a changing inflation rate (i.e., the P/E multiple should be lower when inflation is high, and the P/E should be higher when inflation is low). This idea has been around even longer than Peter Lynch, and you can read more here: http://valuestockplus.wordpress.com/2006/10/31/the-rule-of-20/

      Reply
      • 3. Margaret  |  November 22, 2011 at 12:44 pm

        Actually I should have said “your estimate” of equilbrium P/E is based on estimated inflation of 2%. I know that inflation changes, and along with it equilibrium P/E. My point is that you underestimate inflation – it is closer to 10-11%; it is not 2%. Therefore you have overestimated equilbrium P/E. Equilbrium P/E is around 10%, and therefore the market is NOT undervalued. Current equity prices are close to equilibrium and therefore there is no inherent force that would cause them to rise much beyond current levels.

        My estimate of 10-11% inflation is based on the pre-1994 methodology, a methodology not characterized by overstretching adjustments – hedonistic and substitution adjustments, and the ridiculous notion that food and energy prices should not be included in calcluation of a “core” rate. Further my estimate is much closer to the growth of monetary aggregates relative to growth of real gdp.

        Pardon my mistake in attributing your error to Peter Lynch. I spoke/wrote too quickly.

  • 4. sidoxia  |  November 22, 2011 at 1:13 pm

    Good points. Under your 10-11% inflation scenario, bonds and cash won’t be a fun place either. Equities should be a better hedge against inflation, but I can’t dispute further multiple compression against an inflation melt-up scenario…WS

    Reply
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