Understanding The Rule Of 20 Valuation Tool

Many readers ask that I better explain the Rule of 20 and how to read the The Rule Of 20 Barometer Chart.

Briefly, the Rule of 20 states that fair P/E on trailing operating earnings equals 20 minus inflation. For more on that see S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years and THE “RULE OF 20” EQUITY VALUATION METHOD.

With total CPI of +1.4% YoY, fair P/E should thus be 18.6x on trailing EPS of $98.35 yielding 1829 as fair value for the S&P 500 Index. At its current level of 1640, the Index is thus 10.4% undervalued.

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The yellow line on the chart is that “fair value” while the blue line is the actual Index level. The trend in the yellow “fair value” line provides a visual of the trend in “fair valuation”. A rising trend generally results from rising earnings, but sometimes from falling inflation, rarely both. The recent sideways pattern in the yellow line reflects stalling earnings during the past 12 months.

The gap between the yellow and the blue lines provides a visual of the degree of under or over-valuation of the Index versus “fair value”. Lately, stocks have advanced against stalled valuations resulting in a decline in the market undervaluation, which is reflected in the rise of the thick black line towards the “20” red horizontal line which delineates under and over valuation. The background colors indicate where current valuation (the black line) stands on the risk barometer.

The thick black line is the Rule of 20 value itself (not “fair value”). It plots the sum of the actual P/E on trailing EPS plus inflation. Since “fair value” equals 20 minus inflation, it follows that current P/E plus inflation will equal 20 at fair valuation. So current P/E plus inflation, the “Rule of 20 P/E”, is undervalued when below 20 and overvalued above it. The Rule of 20 P/E historically fluctuates between 15 and 25. Readings below or above that band reflect periods of extreme investor greed or fear.

At the current 1640 on the S&P 500 Index, trailing P/E is 16.7. Add inflation of 1.4 = 18.1 which is 10% below 20, or 10% undervalued.

Understand that the Rule of 20 is not a forecasting tool. A quick glance at the chart reveals that markets rarely trade at “fair value” (the “20” line). It is rather a risk/reward measure providing a totally objective reading of where equity markets trade versus objective fair value. Investors can thus calculate the upside/downside to fair value, thereby appreciate whether this fits their own individual risk profile.

Understanding where markets trade on an objective risk/reward scale enables investors to structure their portfolios dispassionately and rationally. They can monitor economic trends and better appreciate how these can modify investors sentiment and move valuation closer or further away from fair value.

This is one of the goals of News-To-Use: objective monitoring of pertinent economic trends in order to better utilize the Rule of 20, the most useful tool to constantly gauge the risk/reward equation for U.S. equity markets.

I hope that helps. Please let me know otherwise.

 
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7 thoughts on “Understanding The Rule Of 20 Valuation Tool

  1. Denis-
    Could you comment on or address how you figure the rule of 20 would do in a rising CPI environment (as in 1965-1980)? It seems to me the the market multiple tends to anticipate changes in inflation and the rule of 20 would tend to be “behind the ball” in a rising CPI environment.

  2. Excellent explanation. Until now I never understood the chart, but it makes perfect sense after reading your article.
    Thanks!

  3. Dumb question time – Where do you get trailing EPS of $98.35? I’m finding $87.77. Thus, I’m showing the index is overvalued by 19ish percent using the Rule of 20.

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