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Will the ‘Rule of 20’ reign again as the Fed puts the hammer down?

by LLB Reporter
22nd Sep 22 11:02 am

Valuation methodology helps investors gauge the impact of inflation on share prices, new study shows.

US S&P 500 benchmark still looks expensive, even as it re-tests June’s lows and either earnings forecasts need to advance or inflation to recede, if the Rule of 20 holds firm.

“Share prices are falling, the dollar is surging, and the bond market is pricing in a recession as the US Federal Reserve keeps tightening monetary policy and seemingly snuffs out any hope for a pivot or even a pause in its new-found zeal for fighting inflation,” says AJ Bell investment director, Russ Mould. “As the S&P 500 flirts with a 20%, bear-market fall and heads back toward June’s year low, investors have to ask themselves whether US stocks are offering better value or whether there is more pain to come and the so-called ‘Rule of 20’ could be one helpful guide here.

“This yardstick seems to be coming back into fashion after a lengthy period out in the cold and it is getting a new airing because it makes inflation one of its key considerations when it comes to establishing whether a single stock or benchmark stock index is cheap, expensive or fairly valued.

“The origins of the ‘Rule of 20’ are shrouded in mystery, but the legendary US fund manager Peter Lynch is thought to have been an active proponent when he was managing Fidelity’s Magellan fund with such distinction from 1977 to 1990.

“Lynch, also well-known for his assertion that the acronym IPO stood for ‘It’s Probably Overpriced,’ argued that a fair multiple, or price, for a stock was 20 minus the rate of inflation (or, put another way, the rating plus inflation sum to 20).

“For example, if a stock or index was trading on 11 times earnings and inflation was 2%, then the theory would be that there could be some value to be had. Conversely, a market or company that was trading on 18 times earnings when inflation was 8% was seen as overvalued.

“Investors could then debate whether it was best to use historic or forward (forecast) earnings, especially given the notorious unreliability of analysts’ forecasts, at least for cyclical and economically-sensitive industries.

“The current rate of inflation in the USA is 8.3%, according to the US Bureau of Labor Statistics. Applying the Rule of 20 that means a fair price/earnings (PE) multiple for the US equity market is 11.7 times.

“Oh, dear. The S&P 500 index stands, at the time of writing, at 3,789 and Standard & Poor’s analysis is looking for earnings per share of $210 for 2022. That implies a PE of 18.5 times, to suggest the US equity market is way, way overvalued by as much as 35% to 40%, even assuming that $210 earnings forecast is any good.

“The situation looks a little less black if 2023 forecasts are used. S&P expect $240 in earnings next year, to put the S&P index on 16.3 forward earnings. That is still too high by some 30% unless earnings forecasts start to rattle higher very quickly or inflation starts to tumble. The bad news is earnings forecasts are leaking lower in the US right now, not sidling higher.”

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