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/ [12], 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.

