How About That Pesky Measure Still Saying U.S. Stocks Are Cheap?

Apr 16, 2014 11:13 am ET

(For more Market Insights columns, see NI MKTINSIGHT <GO>)

April 16 (Bloomberg) -- It seems like for every doom-and- gloomer saying the U.S. stock market is headed for a 2000-style bubble burst, there’s an optimist behind them saying, “That’s nonsense -- and can I interest you in a flier on an IPO for an unprofitable Internet company?”

There is one old-fashioned measure of valuation that rarely creeps into the conversation, and when it does it creates a heated debate over its significance. The Rule of 20 states simply that valuations are fair when the sum of a price-to- earnings ratio and the rate of inflation is equal to 20.

The rule, which is said to have been embraced by old-school investors like legendary market-beating stock picker Peter Lynch, highlights how corporate earnings become more valuable to investors amid periods of low inflation and, ergo, low interest rates.

The controversy crops up in how you calculate it, and how to base investment choices on it. The problem is the variables - - price, earnings, and inflation. Price is fine: The Standard & Poor’s 500 Index closed yesterday at 1,842.98 and even if you believe the benchmark should be at 10,000 or 1,000, you can’t argue otherwise.

Measurements of earnings, on the other hand, come in enough flavors to rival Ben & Jerry’s. Inflation also is served in various forms and comes under scrutiny due to the shifting methodologies of calculating price changes over the years, not to mention the Federal Reserve’s methods of controlling the cost of living.

Vanilla Earnings

Let’s start with the sort of plain-vanilla flavor of earnings -- trailing 12-month profit-per-share excluding extraordinary items. On that basis, the P/E for the S&P 500 is about 17. Add in the plain vanilla flavor of inflation, the consumer price index that was reported yesterday, and you get a sum of about 18.5. So by our math that’s less than 20.

In fact, the S&P 500 this month will celebrate its fourth anniversary below 20 by this methodology.

Of course, some people prefer a Rocky Road-type of flavor with those “extraordinary items” included in their earnings. On that basis, the measure comes in closer to 20, or just about fairly valued. Others may even prefer a method that Yale University professor Robert Shiller uses to look at profits, which is to take the average inflation-adjusted earnings over the past 10 years. (Ben & Jerry’s would maybe call this the “Shiller Thriller.”) That sort of P/E is above the fair value of 20 before you even add in inflation.

‘Greatest Entry’

It’s important to note that, no matter what flavor of earnings you use, the Rule of 20 can be tricky. Nicholas Colas, chief market strategist at ConvergEx Group in New York, wrote brilliantly about the topic way back in 2012 when people were already puzzling about the prolonged period below 20. He pointed out that early 1982 -- “the greatest entry point for U.S. stocks in several generations” -- had a score well below 20. But, as Colas pointed out, a score of 70 based on as-reported earnings in 2009 was a great time to buy, too.

“As with many equity market ‘Rules,’ what really matters is what happens at the extreme ends of the continuum,” he wrote.

So while the Rule of 20 is not necessarily ringing any alarm bells right now, it’s also not necessarily sending off much more information to base decisions on.

There is also a Rule of 20 in the card game bridge. You’ll have to ask legendary bridge player Warren Buffett about that one.