Rule of 20

"A measure of stock valuations called the Rule of 20 states that the stock market is fairly valued when the sum of the average price earnings ratio and the rate of inflation is equal to 20."

The Rule of 20 is interesting in that should the total of these two numbers be less than 20 then the rule states that stocks are cheap and should be purchased and if they exceed this number then they are expensive and should be sold.  Based on today's S&P500 index reading of 1965 and dividing this number by the expected total earnings per share of the S&P500 of $109, the price to earnings ratio of the S&P500 is just above 18.  Add to this number the Federal Reserve's expectation of inflation of 1.5% and you can see that at this level in theory the S&P500 is slightly undervalued as the total is 19.5.

Looking at the ratio in a little more detail shows just how quickly this indicator can swing.  If you take for example a more realistic inflation number of 4% (I am not sure that even this number is that realistic but it is closer to reality than the Federal Reserve's cooked number) suddenly the total is 22 and the indicator shows that stocks are overvalued.  Furthermore if stocks cannot earn $109 this year and earn say $100 the index is suddenly flashing sell as it is now 23.65 a number not seen since before the 2008 crash.

The problem with looking at one indicator in isolation is thus highlighted.  The numbers are based on expectations and once these change and the real numbers come in the indicator can swing pointing clearly to a buy or sell signal that was not present in the moment.  This dilemma is normally present when an indicator of this nature reaches an inflection point.  Were it to print a number of say 10 (which it did near the bottom in 2009) it is a clear buy indication, as was the sell signal it printed in 2007.  At inflection points it is important that investors look at additional indicators to get a better understanding of the risks before deciding on a direction for the market.

Looking at a second indicator, the Price to Sales ratio, things look a lot different.  The P/S ratio takes the value of the S&P500 and divides it by the total revenue of those companies.  Sales is used for the simple reason that the sales number is the hardest number in the profit and loss statement to manipulate (readers of this blog can refer to the article on IBM and see just how badly earnings can be manipulated) so using this number gives a better idea of the market health.  If sales are growing profits should follow but at present sales are actually contracting so this indicator is now at an all time high.

Another indicator is the price to GDP level.  GDP is the total output of the nation and so a high price in relation to GDP shows over priced stocks.  At present this indicator is back to its 2007 levels.  I could go on but you get the picture that adding these indicators together shows a market that is in dire need of continued Federal Reserve stimulation and that is being tapered at a rate of $10 billion a month.  Continuing on this path and it could spell trouble for the market right around October which has historically been one of the worst performing months in the history of the market - it gave us Black Monday and the Flash Crash among other fun meltdowns.

So while the indicators are signaling trouble there is still time to pull in your horns.  Do not get caught holding the proverbial hot coal that the professional money managers are desperately trying to palm off onto any new comers to the market, or if you really need to be in the market make sure you have adequate protection or have the investment on a very short leash.