Market Insights: The Rule of 20 - a more effective valuation tool?

Milestone Wealth Management Ltd. - Aug 26, 2016
For years now, we have seen countless market prognosticators comment that the equity markets (referring to the U.S.) are overvalued.

The Rule of 20 - a lesser known and perhaps more effective valuation tool

For years now, we have seen countless market prognosticators comment that the equity markets (referring to the U.S.) are overvalued.  The most common equity valuation out there is the price-to-earnings (PE) ratio.  Whether you look at the median or the mean, the PE multiple on the S&P500 is around 15 for the past 100 years.  In other words, the market index price level is the annual earnings of that entity multiplied by said number.  Some look at the past twelve months of earnings (trailing PE), and some look at the projected earnings over the next twelve months (forward PE).  These have both been above the historical average for some time now.  

Another variation of this valuation that seems to be pointed out quite regularly in the media is the Shiller CAPE which stands for the cyclically-adjusted PE ratio.  Some view this as an even better gauge, as it is based on a ten-year moving average of earnings adjusted for inflation, and it has been at an even more "overvalued" level, again, for quite some time and this is likely why it gets significant media coverage.  The media tends to love 'bad' news.  

In it our contention that these are important to understand in relation to where the market stands; however, they are not useful in terms of making overall investment decisions.  If one used this CAPE ratio as a rule, governing whether  to be invested or not invested in the market, or perhaps to be positioned conservatively, they would not have fully taken part in the most recent seven year bull run in the S&P500 in which it increase 100%. 

One may ask if there is a valuation metric that is more useful for making investment decisions.  While there is no single tool that can be relied on in isolation, there is one that we feel provides a better picture for where the market is, in the context of the present environment.  This is something known as the Rule of 20.  Some view this as an old-fashioned rule of thumb; however, it has proven to be a very effective tool in terms of gauging how much exposure one should have in the market.  The rule simply states that fair PE ratio for the market is 20 minus inflation with the total of PE plus inflation generally fluctuating between 15 and 25.  

When we look at this number today (currently ~21), it states that the market is somewhat overvalued.  It is at a level where one should start to look at equity exposure and gradually adjust this exposure lower if we don't start to see earnings expand at a faster pace.  This is a sharp contrast with the CAPE discussed above, which is currently at 27, or roughly 60% (overvalued) above the mean.  From the end of 2012 to the end of 2014, the CAPE went from 22 to 26.5, describing the market as extremely overvalued, and yet the S&P500 price index rose 44% over that period.  On the other hand, the Rule of 20's fair PE over that same period went from a level of about 16 to just above 20.  In other words, from very undervalued to fairly priced or slightly overvalued.  

There are many other examples over the past several decades where simply looking at the trailing/forward PE or the CAPE would have kept you out/in of the market at the wrong times, while the Rule of 20 has proven to be a much better indication of fair valuation.  

To summarize, we view the Rule of 20 fair PE to be the superior tool in characterizing the state of the equity market in terms of fair valuation.  That being said, we do not view this as a forecasting tool.  Evidently, the Rule of 20 fair PE ratio is rarely at 20.  Rather, it is risk/reward measure that objectively indicates where a market is trading at versus its fair value.  As the fair PE moves above or below 20 and closer to 15 (very undervalued) or 25 (very overvalued), one should incorporate this objective metric into an overall investment process and take measures to gradually decrease/increase equity exposure.  In the context of each individual's risk profile, one can better appreciate where the market stands against its fair value.  Taking this into account, along with other factors such as short and long-term interest rates, investor sentiment, fundamental and technical factors, we can objectively guide a more disciplined and structured investment process.