Many pundits currently fear the return of inflation. It is therefore appropriate to verify how the Rule of 20 behaved during years of rising inflation. Could it be that since the market multiple is believed to anticipate changes in inflation, the Rule of 20 would tend to be “behind the ball” in a rising CPI environment?
The first chart sets the challenge. Inflation has been well contained and reasonably stable since 1982, unlike during the 1968 to 1982 period.
As a reminder, the Rule of 20 states that fair P/E on trailing earnings equals 20 minus inflation. Since the Rule of 20 uses trailing inflation, there is the risk it might lag rising inflation expectations and fail to give the right signals as a result.
looking at the longer period of Jan. 68 (CPI +3.7%) to March 1980 (CPI + 14.8%), the Rule of 20 P/E (trailing P/E + inflation) crossed the 20 “fair value” line into the rising risk yellow zone in July 1967 (S&P 500 Index at 95). It remained into the riskier zones pretty much until September 1975 (S&P 500 at 84, CPI +2.9%). The Rule of 20 P/E then dropped deep into the lower risk zone, troughing at 14.2 in February 1978 when the S&P 500 Index began a 23-month rise from 87 to 114 in January 1980 when the Rule of 20 P/E reached 21.5. Equities kept rising for another 11 months to peak at 150 in November 1980 when the Rule of 20 P/E reached 22.2, only to crash 33% to 100 in July 1982 when the Rule of 20 P/E got back into extreme low risk again at 14.1.
During all those years, inflation fluctuated tremendously but always in a rising trend of higher highs and higher lows until Paul Volcker and Ronald Reagan got really serious about it.
These blowout charts help appreciate how the Rule of 20 kept investors prudent until late 1975 amid a roller-coaster equity market. During the following 4 years, corporations adapted to higher inflation, particularly to higher oil prices, and earnings rose rapidly enough to offset rising inflation. Rising earnings, combined with generally flat equity markets, brought the Rule of 20 P/E well into the low risk zone, reaching a 23-year low of 14.2 in February 1978 at 87 on the S&P 500 Index, a level never seen again.
However, the 14-month period between December 1976 and February 1978 was not favourable as equity markets declined 18.7% even though the Rule of 20 P/E was in very low risk range (16) at the end of 1976. It took 2 years to get back on side but, as mentioned, the lows of February 1978 were never revisited.
To conclude, the Rule of 20 worked just as well when inflation was high and rising rapidly, perhaps a suggestion that investors are not as adept at anticipating inflation as generally believed. In any event, investors should realize how much better it is to deal with real, trailing, data on earnings and inflation, rather than trying to crystal ball them.