The Rule of 20 (fair PE = 20 minus inflation) is getting more popular as more and more investors get to know it and appreciate its simplicity and usefulness.
One concern some investors have is the use of the CPI as a proxy for inflation. Some say that inflation calculation methods have changed over the years; others claim that the CPI is manipulated and does not accurately represent true inflation. However, to the extent financial markets use the official CPI for their assessment of inflation, it remains the best benchmark as it represents the views of the vast majority of investors.
The impact that all the QEs are having on interest rates is more troubling. The CPI in the Rule of 20 is but a convenient proxy for a “real discount rate” to apply to equity valuation. As the Fed keeps managing interest rates down, below their free market level, should it have an impact on the discount rate investors use in their valuation?
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors, argues that equity valuation is positively impacted by the QE-induced low interest rates:
(…) Assume that the long-term interest rate, defined by the ten-year Treasury note, is going to be in the vicinity of two percent for the next five to ten years. What would you then use as an equity-risk premium so you could calculate the value of the US stock market? Let’s run some numbers to try to predict where the market is headed.
A traditional equity-risk premium calculation would be 300 basis points over the riskless rate. (…) If you use the ten-year yield and a two percent estimate, you will derive an equity-risk premium comparative interest rate of about five percent. That is two percent on the riskless piece plus three percent on the equity risk premium, for a total of five. This calculation leads you to the basic conclusion that the stock market is priced properly and at an equilibrium level at twenty times earnings. Twenty times earnings is not excessive under this set of assumptions. The market would be neither cheap nor richly priced.
Apply the twenty multiple to the earnings estimates that we have for 2013. (…) For the purpose of this counting exercise, I am going to use $90. Ninety times a PE of 20, which we derive from an equity-risk premium of 300 basis points over the ten-year Treasury yield, gives us an $1800 price target on the S&P 500 Index. (…)
Will the Fed stay in its present mode for that long? No one knows. Given the current concentration of intensity, effort, and communication on the employment situation in the US, you can easily guess that it will take four to seven years to achieve an unemployment rate low enough to warrant the Fed changing its policy stance. One Fed president has now called for continuation of this policy until the unemployment rate is 5.5 percent. Another Fed president has repeatedly called for this policy to continue until the unemployment rate falls below seven percent. (…)
Kotok is adding a 300 points “traditional” risk premium to interest rates. The inverse of that discount rate gives him a P/E of 20 (1/(2% + 3%)). Kotok is precisely playing Ben Bernanke’s tune. The Fed wants to keep rates low enough for long enough to push people into riskier assets, potentially creating a wealth effect that, if translated into more spending, would help pull the economy out of its morass.
As a direct result of the Fed’s actions, real interest rates are currently negative, a truly unusual situation.
Negative long term rates have happened sporadically before, but only during periods when inflation spiked. Currently, U.S. inflation is below 2%.
This is clearly an exceptional situation. Should we normalize interest rates or used them as currently manipulated? Kotok is willing to bank on current low rates on the justification that artificially low rates are to continue as far as the investing eye can see.
Kotok thus derives a 5% earnings yield (20x P/E) assuming 2% long term interest rates and a 300 points “traditional equity-risk premium”. However, the foundation for that “traditional premium” is not readily visible from the chart below:
There is more of a “tradition” in the ratio of EY to interest rates: the range of 0.7 and 1.4 times 10y Treasury yields is more stable if one excludes the two very fat tails in the chart below. On that basis, EY should now be ranging between 1.4% and 2.8%, justifying P/E multiples between 35 and 71.
Obviously, the market has not (yet?) embraced Kotok’s approach. Investors are in effect normalizing interest rates.
Inflation is not as easily manipulated. Its use in the Rule of 20 provides rationality in most exceptional circumstances. The chart below (click chart to enlarge) clearly shows how the Rule of 20 values have historically remained within the 15-25 range except in periods of exceptional greed and fear. The red markers on the blue line indicate actual market highs and lows.
Equity markets constantly oscillate between greed and fear. In fact, precious little time is actually spent at the median valuation level. There is mean reversion but also mean aversion!
The Rule of 20 captures these fluctuations using two basic statistics: the inflation rate and the P/E on trailing earnings. As the chart shows, there have been a few periods when valuations remained excessive for many years:
- The “nifty fifties” resulted in overvalued equity markets between 1968 and 1973.
- A very difficult recession, exceptionally high inflation and interest rates and uncertainties on the eventual success of the Volcker and Reagan medicines kept markets deeply undervalued between 1982 and 1986.
- Wild speculation during the internet revolution brought valuations way above normal between 1998 and 2001.
Such exceptional periods of over and under-valuation have always brought claims of “new paradigms” and “this time, it’s different”, severely testing investors discipline.
With the exception of a brief period late in 2009 and early in 2010, the S&P 500 Index has been in undervalued territory for nearly 4 years, even though the Index has more than doubled during the period! Why is that?
- Earnings have also more than doubled;
- Inflation has remained subdued.
The Rule of 20 currently states that fair P/E is 18.3x trailing EPS of $98.69. That’s 1800 on the S&P 500 meaning 23% upside. David Kotok is thus partly right, but for the wrong reasons.
Should we take the plunge?
The macro risks are pretty well laid out in front of everybody to see:
- Earnings seem to be peaking.
- Revenue growth is near zero.
- Profit margins are very high and flattening.
- The U.S. economy is running on but one cylinder.
- Europe is in as complex a mess as possible.
- China is landing not so softly.
- The U.S. fiscal cliff is straight ahead.
- Nobody really credible is in charge just about anywhere one looks.
That said, I still remember 1982’s gloom and doom. Treasuries were yielding 13% then! The S&P 500 closed at 107 in July 1982, exactly its June 1972 level. Alas, nobody has a monopoly on lost decades.
That said, July 1982 marked the beginning of a powerful bull market that peaked at 330 in August 1987. If you had closed your eyes, pinched your nose and bought on the Rule of 20 reading until it crossed into overvaluation territory in the spring of 1987, you would have tripled your money taking virtually no valuation risk.
Is this time different?
The biggest risk is obviously tied to earnings. Since 1938, there have 13 periods of meaningful earnings decline. Equity markets nonetheless rose during 7 of these periods (see Banking (Betting) on Bankers?).
However, in all 7 cases, inflation declined along with EPS, further proof of the validity and importance of the Rule of 20. In effect, a 1.0% decline in the inflation rate can offset a 5% drop in trailing earnings. Just as important, however, was that investors expectations were lifted by declining interest rates and receding commodity inflation. We can’t expect interest rates to decline much from here, can we? Will the world economic slowdown offset the effect of QEs of all types and nationality on commodity prices?
I debated in September on the prospects for inflation in What If The Fed Has It All Wrong?, erring negatively, arguing that all the QEs in the world are merely pushing on strings while artificially boosting commodity prices and driving inflation upward as a result. Most central banks have squarely abandoned inflation targets, focused as they are on boosting growth.
Can we have our cake and eat it, too?
Perhaps, if oil prices decline.
Saudi Arabia has recently said that it wants lower oil prices. According to Bloomberg, the Saudis recently
chartered at least seven very large crude carriers to load a total of about 14 million barrels in October, compared with about four a month so far this year, according to data from Athens-based Optima Shipbrokers Ltd. Brokers report tanker bookings when the deals are provisional and charters are then sometimes canceled. (…)
A one-way journey to the U.S. Gulf from Saudi Arabia takes about 40 days to complete, according to Optima. That implies the cargoes will probably be discharged in the second or third week of December.
President Obama may decide this is too late for Christmas (and the elections?) and release some of the U.S. strategic petroleum reserves in sync with Europe.
A meaningful decline in oil prices would do wonders for world economies and equity markets:
- world consumers would get an instant and much needed break;
- businesses would also immediately benefit;
- consumer inflation would decline;
- lower producers costs would likely trickle down to consumer prices, lifting expectations of slow inflation for an extended period.
- Israel-Iran: no end in sight.
- Iran is helping Syria’s government;
- Saudi Arabia is helping Syrian rebels;
- Saudi Arabia’s budget needs €100 to balance.
- Venezuelan production? Mexican production? Nigerian production? Etc…
This time is different!
- This time, whole countries are bankrupt and in depression;
- Big countries such as Italy and France are seriously teetering;
- Austerity measures keep being piled on;
- Eurozone politicians have lost control leaving Eurocrats in charge;
- Technocrats are meeting endlessly seeking common grounds to 17 widely different agendas;
- Many major banks are on artificial life support;
Briefly stated, Europe is a catastrophe in slow motion that nobody can confidently predict how nor when it will end;
- The U.S. looks only a little better;
- Not so for U.S. politicians;
- China: landing? Hardly or softly?
- Can China recover without pulling commodity prices, including oil, higher?
- Central banks are down to experimenting, having pushed aside their own rules and regulations as well as anything resembling monetary discipline;
- Monetary stimulus is no substitute for fiscal stimulus. However, few countries, least of all Europe and the U.S.A. are in a position to provide the necessary fiscal medicine.
In all, the world is a mess with little visibility for a turnaround mainly because normal market forces are ineffectual, being relentlessly overruled by political and/or technocratic interventions.
Yet, inflation is not slowing. Eurozone inflation was 2.7% in September, up from 2.4% between May and July. U.S. inflation was 1.7% in August, unchanged from May-June but up from July’s 1.4%. Core CPI has slowed a little but median CPI has held steady at 2.3% since May and the last 2 months annualized rate was +2.4%. The US Daily Index at the Billion Prices Project @ MIT has been accelerating lately, rising at a 3.8% annualized rate since June.
The hope is that central bankers’ bets succeed and growth reappears without higher inflation. If the monetary experiments fail and growth remains slow or gets even slower, profits will decline. If inflation takes off at a rate faster than economic growth, valuation will suffer. Neither “ifs” are good for equities.
Prudently waiting for positive evidence on profits and inflation is a wise attitude. What opportunity cost there might be is offset by the risk avoided. The valuation gap is wide enough to leave ample upside if and when the skies begin to clear. Meanwhile, quality, good yielding stocks remain the safer bets.