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What is the rule of 20 in finance?

In other words, the Rule of 20 suggests that markets may be fairly valued when the sum of the P/E ratio and the inflation rate equals 20. The stock market is deemed to be undervalued when the sum is below 20 and overvalued when the sum is above 20.

familybusinessmagazine.com - Why the Rule of 20 Matter in Stock Valuation -Whittier Trust

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The beginning of a new decade is one of those personal milestones that often prompts reflection and introspection. Where am I in life’s journey? How do I feel about the decade that just ended? What lies ahead?

Investors are no different and may have posed the same questions about the financial markets at the end of last year. Their review of the past decade was quite likely positive and upbeat. Stocks and bonds both had a remarkable run in this period. The S&P 500 index soared by an annualized 13.6% in the 2010s and the Barclays Aggregate Bond index rose by 3.7% on an annual basis. U.S. investors in particular were perhaps also gratified to see the dominant performance of their domestic stock market relative to the rest of the world. U.S. stocks generated cumulative returns of over 200% in the last ten years and outpaced stocks in both the developed and emerging foreign markets by over 150% in aggregate, based on the S&P 500, MSCI EAFE and MSCI EM indexes.

As the stock market gets off to a strong start this year, concerns about valuations are now starting to grow. During a year of virtually no earnings growth, how could stocks perform so well? As Price-to-Earnings (P/E) multiples rise, are stocks expensive now or even overvalued?

The symmetry and numerology of the year 2020 brings to mind the good old “Rule of 20” as a useful way to think about these questions. A tried and tested heuristic in the stock market has been derived from the combined levels of the P/E ratio and the rate of inflation. Over the years, markets have shown a distinct tendency to revert back to a sum of 20 for these two metrics. In other words, the Rule of 20 suggests that markets may be fairly valued when the sum of the P/E ratio and the inflation rate equals 20.

P/E + Inflation = 20

The stock market is deemed to be undervalued when the sum is below 20 and overvalued when the sum is above 20. This seemingly simplified insight has nonetheless been surprisingly effective. Here are some historical observations from Evercore ISI for the Rule of 20.

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Markets rarely trade at equilibrium, so it’s no surprise that the Rule of 20 is also rarely achieved in precision. The combined P/E ratio and inflation rate have ranged from a low of 14 to a high of 34. Over the last 50 years or so, the average P/E is just below 16, average inflation is 4% and the average sum of P/E and inflation, as expected, is close to 20.

Let’s compare recent valuation and inflation trends against this historical backdrop.

Valuations in the last 5 years have trended higher. The average P/E in this period is measured at 18.1, which is admittedly higher than the 50-year average of 15.8. However, the upward drift in P/E ratios is rooted in the fundamental drivers of low inflation and low interest rates, and not in speculation or euphoria as some might fear. Inflation in this period has come in significantly below its 50-year average at just 2.0%. Muted levels of inflation have been one of the most remarkable outcomes of this lengthy economic cycle. As a result, the sum of P/E and inflation in the last 5 years registers at 20.1 which is almost surgically aligned with the Rule of 20. It also provides us with a key insight and takeaway. Higher-than-normal P/E ratios in recent years are being supported by lower-than-average inflation, and consequently, lower-than-average interest rates. The P/E ratio, both forward and trailing, and inflation rate so far in 2020 are a notch higher than the 5-year average shown above. The average P/E this year is close to 19, inflation is around 2.5% and the sum of P/E + Inflation is just above 21.0. a. These levels are only slightly higher than the Rule of 20 norm and still close to fair valuations. b. We also attribute this small uptick in the P/E ratio to expectations of higher normalized growth in the second half of 2020, triggered by the recent truce in the trade war and concerted global central bank easing. Any discussion of valuations or growth at this point would be incomplete without reference to the current concerns about the coronavirus. In this regard, we observe that geopolitical or “geomedical” events rarely have a lasting impact on the markets even though they inflict significant human pain and suffering. At this point, we hold a similar view that the current fears of a pandemic will also pass without meaningful permanent economic damage. We, therefore, believe that our valuation views discussed above in the context of the Rule of 20 still remain intact.

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We believe that the U.S. stock market is fairly valued at these prices. We also believe that a U.S. recession is unlikely in the near future based upon the health of the consumer and the job market. We nevertheless remain vigilant to changing sources of risk and guard against them through a focus on high quality investments. Investment and Wealth Management Services are provided by Whittier Trust Company and The Whittier Trust Company of Nevada, Inc., state-chartered trust companies, which are wholly owned by Whittier Holdings, Inc., a closely held holding company. All of said companies are referred to herein, individually and collectively, as “Whittier.” This document is provided for informational purposes only and is not intended, and should not be construed, as investment, tax or legal advice. Please consult your own legal and/or tax advisors in connection with financial decisions. Although the information provided is carefully reviewed, Whittier cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided. Past performance is no guarantee of future results and no investment or financial planning strategy can guarantee profit or protection against losses. For additional information, please visit our website at www.whittiertrust.com.

familybusinessmagazine.com - Why the Rule of 20 Matter in Stock Valuation -Whittier Trust

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