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Rule of 20

August 2013

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On a year-to-date basis, the Standard and Poor’s 500 Index (S&P 500) is up 15%. This is on top of the greater than 100% advance the index has experienced since the recession lows in early 2009.

A closer look at the year-to-date performance for the S&P 500 reveals that about one-third of this rise was attributable to earnings growth and two-thirds was due to the rise in valuation (Price/Earnings Ratio or P/E Ratio#). Currently, the S&P 500 trades at 14.4 times earnings*, which is up from 13.3 times at the start of the year and from the post-recession lows of 11.1 times in August 2011. At 14.4 times earnings*, the S&P 500 is also nearing its long-term (45 years) average P/E ratio of 15 times, which is presented in the chart below.

#Price/IBES forward 12-month EPS
*IBES forward 12-month EPS
S&P 500: Price/Earnings Ratio 1968 - 2013

At its current level, some investors are suggesting stocks have reached full valuation and have limited potential remaining, especially since the S&P 500 now trades very near its long-term P/E ratio of 15.

This is not the case according to the “Rule of 20” valuation model, which relates the P/E ratio to inflation conditions. Looking only at the absolute level of the P/E ratio leaves out the fundamentally important impact of inflation on valuations.

As presented in the chart below, the long-term (45 years) average rate of inflation** has been 5%.

**CPI less Food and Energy year-over-year %
Annual CPI: Average Rate of Inflation 1968 - 2013

When the long-term average inflation rate (5%) is added to the long-term average P/E ratio (15X), the sum totals 20, hence the “Rule of 20” valuation model. This simple model has been very effective over time at identifying periods of over and under valuation.

In our opinion, the reason the long-term average P/E ratio has been 15X is because the long-term average inflation rate has been 5%. It is the existing inflation rate that is the primary determinant in setting the fundamentally appropriate P/E ratio level.

Presented in the following chart are historical P/E ratios calculated using the “Rule of 20” valuation model (blue line) and the actual P/E ratio (red line) between 1968 and 2013.

Rule of 20: Price/Earnings Ratio Expected vs Actual 1968 - 2013

The actual P/E ratio, not surprisingly, moves with greater variability both above and below the “Rule of 20” P/E ratio. However, it does effectively regress back towards this fundamental valuation over time. This simple valuation model has provided investors with a very good framework for determining valuation conditions.

Some may ask if the “Rule of 20” still holds true if you remove the high inflationary 1970s and only consider the more modest inflationary period since the early 1980s. The following data suggests the model remains effective.

1982 to 2013

Average CPI% was 3%
Average Actual P/E ratio was 16.7X

Currently, the CPI (less Food and Energy year-over-year %) has been increasing at a 2% annual rate which, according to the “Rule of 20” model, would suggest the S&P 500 P/E ratio should fundamentally be closer to 18 times. This would translate into an additional 25% rise in the market valuation.

We believe stock investors should be more focused on inflation conditions than the absolute level of the market P/E ratio. If inflation can remain near recent levels of about 2% (which we believe is likely), valuations have further room to improve and drive higher stock prices.

We remain focused on understanding the current trends in fundamentals because it gives us the best probability for success. And if you’re an active social media user, please consider sharing this topic with your acquaintances.