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When The "Rule Of 20" Says "Fight The Fed"
ConvergEx's Nick Colas dusts off a golden oldie of stock market valuation – the "Rule of 20." The basics of this heuristic are simple: the addition of the U.S. equity market’s price/earnings ratio and the current inflation rate as measured by the Consumer Price Index should trend around 20. If the current inflation rate is 2%, for example, then stocks should trade to an 18x current multiple. That may sound too simplistic, but since 1914 the average of this summation is 19.3 – pretty close to the catchier “20.” But, as Nick explains, what the “Rule of 20” handily captures is the essential relationship between corporate earnings (a.k.a. cash flows) and discount rates (primarily driven by marginal inflationary expectations.) Here is where the current “Rule of 20” math takes a surprising turn. With CPI inflation at 2%, the market should be trading for 18x current earnings. We, like Nick, see the reasons for this shortfall: either the market is worried that corporate earnings are about to tumble or inflation is much more of a threat than a Fed-supported yield curve currently indicates. Or… gulp… both.
Via Nick Colas of ConvergEx:
Anyone who lives in New York for longer than a few weeks develops a set of rules that make life easier. Gotham is, after all, one of those cities that rewards planning for even spontaneous moments. Since I have lived here for the better part of 40 years, let me share a few of my personal favorite “Rules”:
- Never order fish in a restaurant on a Sunday or Monday. With the exception of super high-end sushi and fish places (think Nobu or Milos), most fresh food is delivered to Manhattan eateries on Tuesday, Wednesday and Thursday. That, by the way, is why every cross town street is crowded on those days. By the end of the weekend or - worse yet - Monday, nothing in the fridge is fresh. An adjunct directive: no Hollandaise sauce. Ever. Seriously. Read Anthony Bourdain’s Kitchen Confidential if you need more color on either point.
- Cab driver shifts typically end between 5 and 7 pm every day. This is because there are two peak periods of cab demand – the morning commute and dinnertime. A driver needs to capture one of these periods in order to have a successful day’s work. As a result, there is a huge shortage of yellow cabs around 6pm, as daytime drivers hand off their vehicles to the evening shift. You will not get a cab in midtown during this time. Ever.
- If your teenage son or daughter has purchased a small plastic bag of stale looking green leaves from a gentleman in one of the cities smaller parks, you are under no obligation to tell them that they have spent $50 on oregano lifted from a pizzeria. Side effects will include coughing, wheezing, and shortness of breath. And not much else.
Just as living in the five boroughs comes with an unofficial rule book, so does equity investing and trading. A few quick and easy ones:
- Don’t buy a stock that is setting a new low. Let it stabilize. It’s better for your mental health. I would eat broiled codfish on a Monday evening in the middle of summer, smothered in warm leftover Hollandaise, before I would take a flier on a new low.
- Don’t short new highs. Same goes for selling a long position. Let it run.
- Sell when you can – not when you have to.
- Cut your losses early; you can always buy it back.
Yet for all the easy aphorisms, other useful Wall Street guidelines have fallen into unwarranted disuse; today, I would like to resurrect the “Rule of 20.” The basic parameters are as follows:
- Equity valuations – we’ll use the price/earnings ratio of the S&P 500 as a proxy in this note – are fundamentally beholden to inflationary expectations. There’s good fundamental logic here. To calculate a notional “Fair value” for a stock or the market as a whole you have to discount future cash flows (a.k.a. earnings) by some interest rate. The bedrock of what moves any fixed income security is the market’s expectations of future inflation, layered over with secondary issues such as maturity preferences and the specific riskiness of the bond.
- When you add current inflation rates to current market valuations, the sum of these two variables tends to equal something close to 20. We’ve included several charts immediately after this note to back up that claim.
Essentially what our work show is that when you take the S&P 500 current as-reported P/E ratio (courtesy of http://www.multpl.com/, which uses Robert Shiller’s data as its benchmark) and add the current year on year change in the Consumer Price Index, you get a sum which averages 19.3 from 1914 to the present day. The standard deviation of this calculation is 5.4 from 1914 to 1990, an impressively tight relationship through two World Wars, a Cold War, one Great Depression, over 10 other recessions, the birth of rock and roll and disco and punk and several iterations of reggae, brown polyester leisure suits, and untold other notable historical events.
The period from 2000 to the present day is absolutely unique in modern financial history, in that the “Rule of 20” stopped working. The dot-com bubble took stock valuations to unsustainable levels, starting in 1999 and rolling forward to 2001. We got, essentially, the Rule of 30, then 40, then almost 50. Valuations almost returned to normal – “20” in 2007 – before the Financial Crisis pushed corporate earnings into rarely-seen negative territory. We briefly had the” Rule of 70” in 2009 because companies were making so little money. - The fact that buying the “Rule of 70” was a great trade shows the limitation of such guidelines. As with many equity market “Rules,” what really matters is what happens at the extreme ends of the continuum. Early 1982 – the greatest entry point for U.S. stocks in several generations – had a “15” score, meaning stocks were cheap. And the best trade of the last 5 years happened at the other end of the spectrum at the aforementioned 70.
- Even the most cursory assessment of the history related to the “Rule of 20” should leave you with some questions related to equity market valuations. Consider that the standard deviation of this math since 1990 is 11.6, or more than double the 5.4 I mentioned previously as the one-sigma variation of “P/E plus CPI” addition we are discussing here. A piece of that is the wild ride for corporate profits over the last five years, to be sure. But shouldn’t that volatility argue for a more conservative approach to a “Fair Value” price-earnings ratio, rather than the current 18 score on the “Rule of 20” calendar?
- The other wild card, with implications reaching as far as Federal Reserve policy, as well as closer-to-home matters like stock valuation, is inflationary expectations. The reason the “Rule of 20” exited the lexicon of most investors in the last decade is because for over 2 decades Fed policy has generated modest levels of price increases. Funny things happen when you start to assume a historical challenge like inflation is no longer of any concern. One of those outcomes is that investors might decide that stocks deserve a permanently higher valuation parameter.
- And yet… And yet… The Federal Reserve’s remarkably aggressive balance sheet expansion since the Financial Crisis has certainly reinvigorated the debate over inflation. It is, thus far, about as useful as a discussion about how the Yankees are going to do in the World Series. But, just as with baseball, there is always next year.
To sum up, I think you’ll be hearing a lot more about the “Rule of 20,” and the role of inflation in stock market valuations in the coming years. Maybe the Fed will be proven correct, and they will be able to return to a more normal course of monetary policy without igniting unusual price increases as a result of all the excess liquidity still sitting in the financial system. We are all cheering for that outcome – even the most bearish investor knows it is a lot easier to get rich in an up market than one in cyclical decline.
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Don't just fight it, beat the living shit out of it.
Order 66
Rule of 20 is missing a parameter--it is a vector quantity. You could hold at 20 throughout any century, but if you're at 18 p/e+2% and it goes to 10 p/e+10%, you just got hosed right up the butt. I like the general rule of that douche bag Buffett. He says it is the direction of interest rates, not their absolute value, that will dictate returns. When rates are at 2%, there is no way but up and your portfolio is about to be sponsored by Red Bull.
The Bernank, through radical, insane monetary policy, has so distorted the supply/demand curve and the ability of investors to engage in true price discovery, that he's helped produce a record number of simultaneous bubbles, as a means of attempting to create surrogate economic growth during a period of deep, structural (not cyclical; sorry Paul "Let's Stage An Alien Invasion" Krugman) economic rot.
This is similar to the strategy proposed by Krugman back in 2002 when he expressly suggested that Greenspan should create a housing bubble to replace the dot.com bubble (which Greenspan, in fact, did). Krugman denies he suggested doing so would be a good idea and has maintained he was merely predicting what Greenspan would ultimately do, but Krugman lies, and his own words viewed in proper context clearly establish he desired such a sequence of events.
We're at a point now whereby fundamental interventionism in the underlying economy by central fractional reserve banks is at an all time high.
The number of bubbles that now exist from literally insane central bank monetary policy, whether they exist in bond, equity, credit, commodity or other markets, is at an all time high.
It will all end in tears. Fiat printing will never be able to compensate for a lack of real economic output nor will it ever be able to prod aggregate demand on anything remotely approximating a sustainable timeline (just the opposite-- deleveraging-- will in fact be the ultimate result).
Ben Bubbles Bernanke, for the loss.
"The Bernank, through radical, insane monetary policy, has so distorted the supply/demand curve and the ability of investors to engage in true price discovery, that he's helped produce a record number of simultaneous bubbles, as a means of attempting to create surrogate economic growth during a period of deep, structural (not cyclical; sorry Paul "Let's Stage An Alien Invasion" Krugman) economic rot."
One has to wonder why there's such a preponderance of head-scratching, why things are deviating away from the "norm." You see, when one has such difficulty answering these things then it might be prudent to question the premise.
I believe that the entire paradigm is dead-ending, and that the elements of supply and demand being applied to it is meaningless; and as such, [only] meaningless results are/will be showing up.
The value of gold as measured in fiat is a great example. How often do you/we hear people being excited that gold will be "worth" more fiat? When one looks closely it should be clear that this is entirely absurd. So too is the absurdity on measuring things based on the old "growth" paradigm. As much as I agree that things are distorted, I don't believe that it's healthy to set about correcting or concentrating on a distortion that is itself based on a distortion (bad premise): if one wants to go clinically insane then yes, go ahead.
I think that there's a higher probability of an alien invasion than in "fixing" this bad premise. And for the record, I'm not betting FOR either.
I got your Rule of 20 right here - buy 20 ounces each month
When the (stock) market is as rigged as it is, I an't buying no stinkin stocks.
"buy 20 ounces each month"
but but .. There's Not Enough Metal to buy 20 ounces each month
Plenty of Silver still out there :-)
Make mine 666 ....
O Happy Day !! NYT has Newsweeked itself !!.....misses big.
http://www.bloomberg.com/news/2012-10-25/new-york-times-co-falls-after-r...
This Is The Week The DJIA Says Goodbye To 13K Forever http://chartistfriendfrompittsburgh.blogspot.com/2012/10/this-is-week-dj...
It seems what we have here is an economy adrift in leftover Hollandaise sauce............
The "rule of 20" is the most useless metric I have seen yet for evaluating stock prices, the economy, market timing..........
rule of 20 is really simple: buy equities when they are expensive and you're portfolio will be worth about 20 bucks when you are done suffering Death by Bongo.
"The fact that buying the “Rule of 70” was a great trade shows the limitation of such guidelines."
That's a pretty diplomatic way of saying that the whole concept is horseshit and he could have spent his time writing about something else.
Right except now the numbers are based on fraud. Perhaps GS should rename it to the rule of 20 fraudsters with GS among them.
Don't fight the FED. Never! Fight the enemy within. Our fears and greed and complacency. The FED is just this old man behind the curtain pulling the levers.
That's right - do not fight the Bandish Back-up Bank. Fight the foe within us, which is thought, the longing for freedom and the wish to better our lot. The Bandish Back-up Back was aset the earth that the Lord's will be done. When it buyeth aught, so shall yee, and yee thilk as it. Blessed be the mains that be, for theirs is the Lord's work.
Are you the 3rd or the 4th coming? I lost count...
'Tis a sin to hold that one is an ofcoming or in any way a deal of White Christ. I am NOT White Christ, and neither is any man. Instead, I am a lowly thane of White Christ that axeth naught in this life but the opening to do His will, and never mine. His are the mains that be, and His is all that is. May GS, JPM, HSBC, BOA, RBS and all the other name-forshortened mains shine upon thee and lead thee on His path, and may thou never think or utter a free word.
BOTH
What the yield sheweth is right. Earnings will never tumble. The Lord will see to it, as great wrong hath newly been done to the fellowship. That Theedland should ax to have its gold back-ups edturned mayhap be the greatest sin against the world-network of all time, and is a sake for war. It sheweth a want of trust in our bankers, who kindly do none other than the Lord's work. Now is the time to buy.
Wouldst thou passeth thine Grey Poupon?
I'll hand thee the truth - that full troth in the mains that be will spare thee. Shun the Grey Puck of freedom, thought, and hard work. Do as the midmost steerers wish for thee to do, and thou shalt be spared.
There is going to be a lot of fresh bear carcass lying around to eat if you don't like fish.
quin, i disagree, i think this is 2000 all over again while everyone is looking for 2007.
If money has been coming out of markets (and some put into 'safer' securities (bonds?)) -- then can we assume that money is coming out of banks also, or has already done so? People draw down savings accounts before selling stocks or cashing out 401ks. Been curious if there's a stealthily slow bank run going on. Gotta have cash on hand to pay bills and whatnot. And with interest rates at ZERO, WHY NOT just take it out... buy a little gold-n-silver, cash it out with a possible gain or slight loss (in the case of short term holdings). Everyone knows the mechanations of pumping billions/mo. isn't doing the average American ANY good..
Here's what the 85 Billion dollars a month looks like that's propping up the system:
1001111001010011001010001001000000000
or
13CA651200
I want the job of typing that in every month.... Easier than the keyboard in "Lost"...
If thou takest fee away from the cheapings, it shall be put to the cheapings again. What kind of a dolt would think any stead but the cheapings sicker for his fee? The Lord can rear fee from naught. However stealthily a man seek to withdraw his worth from the world-network, the Lord wote it. The same will be shopen from naught and put in again. Do not think that thou canst outwit the Lord or his fellowship, nor shalt thou seek to understand. None but He and His chosen steerers can understand and speak the true tongue of naughts and ones, which will spare us all. Instead, put all thy troth in Him and heed His great men of the Borough and Wall Street. The pumping in of naughts and ones shall go on forever, and it doth every man ALL good.
As an aside, thou mayest NOT have His work!
I fight the FED with shiney stuff
Just don't carry it in a suitcase ....Man robbed of 2.6 million in gold ..http://news.yahoo.com/video/man-allegedly-robbed-more-2-193000694.html
The only reason to have a bank account is so the Apmex checks clear and to get cash once in awhile.
OR, the 14.5 P/E we're stuck with today already reflects the discount that comes from complete skepticism about the Fed's ability to sustain the cloud of hopium it has blown over the market.
IOW, in a more "normal" environment, P/E would be higher, but everybody knows that deflation is still out there.
When I was in business school, it was 13.
Is he really trying to tell us that TPTB circle went to 70 during bubble mania and is now back to 20? BTW - smaller shopping lists are easier to manage, so "20" seems like a good number.