seeing as 17x is the average market multiple and 3% is the average inflation rate, all the rule of 20 is saying is that when the market and inflation are below their historical averages, the market is cheap, and vice versa. it also can’t deal with unique sitatuions such as stocks trading with a P/E of 30 in a 10% deflation environment and it would’ve said that stocks are overvalued for all of 1922-1929 so you would’ve missed out on a bull market that saw gains of over 400%. it also says that stocks are expensive from 1933-1937 (despite a 100% gain for the period) and says that stocks are cheap in mid-1937 right before the 50% crash. the worst indicator of all time.
That’s why I feel we will go through deflationary/disinflationary pressures for a long time. The young generation is screwed. Student debts (mostly in disciplines that have no job openings) and very few job growth. Growth at below 3% for a while. If not unemployed, they are underemployed. Baby boomers are retiring much later due to a myriad of reasons. Governments at all levels (municipal, state, federal) deleveraging. This is a lost generation that will have less spending power than their predecessors.
Yes and no. Right now it’s one of the best shorts now its ever been in its history IMO. But can you execute on it? I’d be prepared to sit in this for the next 18 months regardless of the volatility at a <10% rebate. Can you do that in a PA? It’s easy to say you will short something but the execution is a lot harder than buying a stock.
Fair enough, I wouldn’t be able to hold it in for that long…not all men were meant to dance with dragons…
Matt, you must be calculating the ratio incorrectly. Looking at Denis’ analysis, which goes as far back as 1927, you can see the following:
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In 1927 the rule of 20 value was 8, indicating undervalued equities (which you say is followed by a 400% rally)
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In 1932 the rule was -0.6, the only time it has ever gone negative. As equities rose by 100% during that period, as you say, the rule of 20 rose to reflect the more accurately priced markets. 1937 started with a rule of 20 of 20 and declined to 10 as the market value of equities declined.
More recent experiences:
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In 2000 and 2007 the rule of 20 was above 30, the only time it has ever broken 30, indicating that the market is highly overvalued.
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January of 2009 the rule was below 12, indicating equties were extremely undervalued
I agree with Denis that the CAPE is too simplistic. Inflation plays a more complex role in the denominator of that ratio than most analysts care to assess.
yes sorry. i accidently selected the dividend column in my Schiller historical data instead of the earnings column. the indicator gave wrong signals from 1900-1920 and wasn’t very useful in helping determine tops and bottoms very well in sideways markets nor in big runups. as for 1937, i see that the indicator says buy in 1937 before the crash at 18-19. i’m also seeing an indicator of under 20 for the years 1922-1929 with no indicator to get out of the market before the crash. it just says keep buying. i see it said to get out in the early 60s, it was a poor indicator in the 1970s and told you to start getting out of the market by 1996. the indicator was above 20 for most of the 21st century, even near bottoms of market cycles. i wouldn’t call it an indicator if it can’t tell you when some of the most overheated markets in history are overheated and is terrible with its timing when it does tell you. an indicator is useless if it can’t help you more than 2 or 3 times in a century.
it still stands that its a terrible indicator as all its saying is that in a normal inflation environment, buy when the P/E is below its average and sell when it’s above. and further, never buy in a high inflation environment and always buy in a zero or negative inflation environment.
for most of history, the indicator hugs the 20 line (intuitively so as it is just average inflation plus average P/E ratio) so as an INDICATOR, it doesn’t really tell us anything that isn’t known already.
Matt I think you’re getting hung up on this because I used the word indicator further above, and that’s not what this is. As I eluded to in that same paragraph, this is not a tool that will tell you when to buy and sell, this is a valuation metric that tells us whether equities are over valued or undervalued, and to what degree. As you know, markets fluctuate for a variety of reasons, and there isn’t a single indicator out there that can tell you what the market is going to do next.
The reason why this tool is useful, is that currently it tells us that equities are not overvalued, as the CAPE would suggest. The CAPE has convinced people that we are set for sub 2% equity returns, when in fact that ratio is fundamentally flawed due to the type of earnings that it uses and it’s failure to put any context around the period in which those earnings are being measured.
I encourage you to read these and decide for yourself.
http://www.news-to-use.com/2012/11/the-shiller-pe-alas-a-useless-friend.html
http://www.news-to-use.com/2010/11/the-rule-of-20-equity-valuation-method.html
Thank God we’ve found an indicator that tells us it is still safe to buy.
I moved 50% of my equities portfolio into RWM this week. I don’t want any beta anymore. I’m done. My long positions remain very selective. I’d take some specific shorts like Bro if I had the skill, but RWM should cover me well.
you can’t even compare the CAPE to the Rule of 20. the CAPE attempts to remove the effect of temporary spikes in profit margins. the Rule of 20 assumes profit margins are unimportant. with profit margins at an all time high and what, something like 50% above the average, obviously there’ll be a big difference between the two indicators.
i stand by the fact that the Rule of 20 is hardly better than just comparing the current P/E ratio to the historical P/E ratio. saying the Rule of 20 is more robust than the CAPE is just sad.
i’m not even really defending the CAPE. i’m just saying that the Rule of 20 blows and has been a very bad valuation metric over time because it is the opposite of robust. not only does it not tell you when to buy or sell, as a valuation metric, it sucks. you can’t cherry-pick the time it worked 50% of the time and disregard the time it didn’t work 50% of the time. and the 50% is probably pretty close in reality because for most of history, all it says is that when the market’s P/E is below its mean, buy, and when its above, sell.
the Rule of 20 is the Pet Rock of valuation metrics.
I don’t really even take specific shorts in a broad sense, I would have 50-60 shorts to hedge out the book and run it low net or net neutral. Of course to your point those 50 would be specific and carefully chosen but it’s a whole other ball of wax to run just a few shorts in a PA vs. run an institutional diversified book of shorts which is what I was trying to explain to P. The execution on shorting is hard and it can be emotionally difficult to see some piece of crap stock rip in your face for no reason or a bad reason, so I never take big positions and I’m willing to hold them for up to 2 years if necessary provided the rebate is low.
I don’t like to “trade” shorts or even longs very much for that matter because the market can and does wander around quite a bit on any particular small cap price. I look for specific situations where I feel very confident the market will ultimately end up at a particular number (or more likely a range) that has wide divergence from the current number, and then I’m prepared to wait for that to happen. Most of the time it’s like watching paint dry, I try to run the least exciting portfolio you can imagine – no Chinese stocks, would never short HLF, don’t trade the quarter, etc. Just looking for those slow money opportunities when the market has lost its mind and is willing to pay me 50% or more over a 1-24 month period with low risk.
Matt, I appreciate the critiques.
First of all, the rule of 20 was invented as an improvement and complement to the CAPE, so i do think it’s appropriate to discuss the two together. The adjustment here is based on the understanding that the earnings used by CAPE are ‘reported earnings’ rather than ‘operating earnings’ and this has a drastic impact on the CAPE output. Reported earnings varied drastically from operating earnings during the two crisis in the 2000’s. Before 2000 these did not vary more than 20% in any year, but in 2002 they hit 40% and in 2009 they varied by 80%. When analyzing individual companies, you should absolutely use reported earnings to monitor the company’s management, however that becomes rediculous when analyzing the market as a whole, and more so for the 2000-2009 time period. Ok, why does that really matter? Because in 2008 the earnings used by CAPE dropped from $85 to $7, in large part to a small amount of companies having ‘unusual’ losses. 80 companies were able to reduce S&P earnings by $27. These companies, which made up 6.4% of the index were able to reduce earnings by 29%. These earnings are inaccurate and still affect the CAPE today by reducing the denominator more than what is an accurate representation of earnings.
Secondly, and I’m stealing this from denis because I can’t word it any better, is that many of the companies that recorded huge losses in 08-09 either went bankrupt or were substantially restructured or acquired. The Shiller PE, measuring 10-year average earnings against a current index, is thus including in its denominator, during 10 years, the huge losses recorded by companies that are no longer included in its numerator, these companies having in fact been replaced by other, profitable, companies.
Lastly, I think there is room to debate whether margins are at unsustainable highs or in a period of prolonged elevation due to an increasing share of profits generated in countries with more favorable tax laws. ISI calculates that there are 135 S&P companies where the foreign effective tax rate was less than 20% in 2012 and that the effective tax rate on the foreign earnings of S&P 500 companies was 25% in that year, down significantly from 29% in 2008 and substantially lower than the 35% US rate. Healthcare has seen its foreign tax rate drop from 21% to 12% since 2003 and IT has seen a drop from 28% to 10%. These two sectors account for an increasing portion of the S&P capitalization, 33% compared to 13% in 1994. This is not to say that margins can’t come down, I just think that there are some structural issues at play that may allow margins to stay elevated for longer than many people expect.
I make no claims that this tool will tell you when to buy or sell, and there are, in fact, no tools that can do this. I have no doubt that at points in history the rule of 20 told us that equities were valued fairly right before a market drop or a market rally. The rally in the market in the late 90’s was based on speculation, not fundamental valuation, and therefore I would expect this metric to indicate that equities were overvalued for many years. Yes, if you used this improperly, you would have been short the market from 97-02. The usefulness of this tool is to measure equity valuation and then use the many other tools available to determine how to act going forward. Right now, it tells us that equities are fairly valued while the CAPE is saying they are massively overvalued, and if for no other reason I think it is a very useful tool.
fair enough about the CAPE. i’ve never really been a huge CAPE follower anyway. as for margins, yes, there is opportunity for a new normal in margins and reversion to the mean is not imminent by any means (as low taxes and interest rates are the sole factors and these will take a long time to revert).
i just fail to see any robustness in the Rule of 20. it’s just a fancy name given to a poor indicator that measures what everybody looks at first anyway (i.e. current P/E vs. historical P/E). its like saying the solution to valuing the market is to use the most basic valuation tool which can be wrong for decades at a time. it just happens to be working now. when will the next 10 year streak of poor predictions begin? tomorrow? right now! next year? maybe. that’s why its a bad valuation tool. a tool should be helpful far more than 50% of the time, or else it has no use, and cannot be considered a tool or indicator or whatever we’re calling it.
Absolutely. 90% of the time this metric will tell us equities are somewhat close to fair value and will give us no meaningful information on the direction of equity markets. This is useful however during the extremes and in periods like today when one of the most widely used indicators is screaming sell.
You may not care much for the CAPE, I certainly dont, but there are plenty of advisors out there who will point to that chart and hammer on the fact that it has done so well in the past. I believe the rule of 20 is useful for anyone who is trying to have that conversation.
agreed. as is the Rule of 17.
This turned out to be solid, haven’t really lost anything through this correction. I imagine Bro has had a few great weeks for his fund.
watch your butts!
Indeed sir, indeed. I am in positive territory since the volatility started. My portfolio does better in down months than in melt up months where only low quality speculative stocks are up and real stocks are flat or down, such as April or August. My short book, mainly comprised of low quality small caps, is getting blown out with many of the stocks down 8-10% today and breaking their 52-week lows in recent weeks. That still leaves main of these 80-100% overvalued but it’s a start.
This all seems exceedingly rational.
I’m actually fine with cash, have spent years all cash, and years all-in w leverage. Right now I’m 100% cash, except for some business investments which are doing their thing and uncorrelated with the market. I’ve seriously got jack shit for investment ideas, for reasons similar to what Bchad points out. And I’m not a fan of forcing ideas.
General plan – sit quietly, wait and watch carefully. Ideas naturally present themselves with time.