Edge and Odds

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Edge and Odds

Invest with smart knowledge and objective odds

***EQUITIES VALUATION

THE RULE OF 20 STRATEGY

January 23, 2019

I was recently able to get one of our sons (Eng., Math, Computer Sc., MBA/MIT) build a model to assess how a rational, sensible and disciplined use of the Rule of 20 could help investment returns by optimizing the cash/equity mix to systematically manage risk.

The Rule of 20 is not a timing tool but it can help modulate equity exposure (risk on/risk off) given certain equity valuation ranges. Since nobody knows the future, the Rule of 20 provides an objective reading of equity markets valuation only using known data. Since equity markets naturally cycle repeatedly from fear to greed to fear, a disciplined and patient use of the Rule of 20 could be a great risk management tool.

The Rule of 20 P/E (actual P/E + core inflation) nicely fluctuates between 16 and 24 around its “20” median. From a strictly valuation viewpoint, holding equities below 20 should prove less risky and more rewarding than holding equities above 20. Since valuations always return to the steady 20 mean, cycles are predictable, at least in their valuations trends.

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I have asked Danny to calculate investment returns since 1957 based on a set of rules stipulating cash/equity combinations at various Rule of 20 P/E ranges. The guiding principles for the rules are best described with a few quotes from famous investors:

  • The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions. (Seth Klarman)
  • Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria. (Sir John Templeton)
  • Be fearful when others are greedy. Be greedy when others are fearful. (Warren Buffett)
  • You don’t have to trade with Mr. Market when he wants to, but only when you want to. (Benjamin Graham)
  • It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent. (Charlie Munger)
  • We don’t have to be smarter than the rest. We have to be more disciplined than the rest. (Warren Buffett)
  • Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto, Margin of Safety. (Benjamin Graham)
  • You must weigh not only the alluring probabilities of being right, but the dire consequences of being wrong. (Peter Bernstein)
  • Buy not on optimism, but on arithmetic. (Benjamin Graham)
  • Rule No.1: Don’t lose money. Rule No.2: Never forget rule No.1. (Warren Buffett)
  • Cash combined with courage in a time of crisis is priceless. (Warren Buffett)

We don’t know the future and trying to forecast it has been proven futile time and again. But we know there are valuation cycles that can be exploited using simple arithmetic to rationally calculate our margin of safety: at any given point in time, what is the valuation downside risk and how does it measure against the valuation upside potential? Unlike other valuation gauges, the Rule of 20 provides very consistent trends around a stable median.

Using known trailing earnings and inflation data, we can readily see where equities are valued on their 16 to 24 Rule of 20 P/E range, calculate the valuation downside and upside and decide whether we have an adequate margin of safety given our own individual risk tolerance level. At a Rule of 20 P/E of 20, the valuation downside (20 – 16 = 4/20 = 20%) equals the valuation upside (24 – 20 = 4/20 = 20%). “Twenty” is thus the neutral, “fair value” level where valuation upside equals valuation downside. Below 20, the risk/reward equation tilts more favorably and vice versa. Simple “buy low, sell high” strategy.

We don’t have to be smarter than the rest, we have to be more disciplined than the rest.

This is not a backtest exercise where one tries to find a best fit on a set of past data. Rather, I established a set of rules to rationally and sensibly modulate the cash/equity mix taking into account that:

  • it is always best not to lose money;
  • equities tend to rise over time, along with corporate profits;
  • valuations always return to the Rule of 20 mean;
  • it is always best not to lose money.

The rules allow the valuation cycle to fully mean revert before triggering a new series of moves in the cash/equity mix. So after the maximum equity exposure has been reached on the R20 down journey, the exposure remains at this maximum until 20 is crossed again after which it is pared down as valuations keep rising. Similarly, cash is kept at the maximum level reached on the way up until the R20 P/E crosses 20 again on the way down, after which it gets reduced as the R20 P/E declines.

This is not a strategy aimed at regularly performing above market averages. In fact, the Strategy can never beat a rising market which it can only match if 100% invested. This is a strategy aimed at maximizing absolute returns while managing absolute downside risk smartly and systematically. If well set, the rules should allow to closely match equity returns in a rising market and to significantly protect capital in a declining market, preserving the investment base for the next upturn.

The actual strategy details will remain proprietary but I will share the results of the strategy as if it had been applied since 1957. I will also provide on Edgeandodds.com the current strategy readings and the changes when they get triggered. These should never be seen as investment advice, simply information on what my particular strategy says.

As a token of appreciation to significant donators to Edge and Odds, I will soon add a section to the blog that will detail the Strategy moves and monitor how a real investment in a S&P 500 ETF will behave going forward strictly obeying this Rule of 20 Strategy. Free riders are very welcome on this blog but I must find ways and means by which I can thank readers who voluntarily and generously contribute to the ever rising costs for the research supporting this blog should they find it useful.

Warning: following this Strategy can be very boring and can be hazardous to the relationship with your friendly broker. In the last 62 years, the Strategy has triggered 127 changes in the cash/equity mix, or about 2 per year on average. Some periods were fairly active but there were many intervals with few, if any, movements, requiring investors to develop personal interests other than equity investments. Paul Samuelson once quipped that “investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” Be warned.

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1957-2018

The Rule of 20 strategy I set out returned 9.7% annually between 1957 and 2018 compared with 6.6% for the S&P 500 Price Index. An investment in January 1957 would be worth 5.7 times more today using the Rule of 20 Strategy than buying and holding the S&P 500 Index during the same period.

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As explained, the Strategy aims at capturing as much as prudently possible from rising equity markets but to protect precious capital during significant corrections and bear markets. The Strategy proved especially protective in 1969-70, 1972-74, 1987, 2000-02 and 2008-09.

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  • 1957-1987

With the same rules, the Strategy returned 9.4% annually between 1957 and 1987, significantly outperforming the 5.5% return of the S&P 500 Price Index.

  • 1988-2018

I only have S&P 500 Total Return data (cum dividends) since 1988. This period is characterized by a 5.5-year span between June 1997 and February 2003 when the rules dictated to remain totally out of equities because of uninterrupted excessive overvaluation. Between June 1997 and March 2000, the Total Return index jumped 76% against a 14.2% increased in the R20 Strategy all cash portfolio. But during the subsequent market rout to February 2003, the Rule of 20 Strategy portfolio appreciated 10.1% while the S&P Total Return Index cratered 43.2%. For the whole trough to trough period, the market returned zero in total while the Rule of 20 Strategy returned 25.7% entirely from its riskless t-bills portfolio.

For the whole 1988-2018 period, in spite of being all cash 31% of the period, the Rule of 20 Strategy returned 10.7% annually, bettering the 9.8% return from the Total Return Index and nicely protecting capital when needed.

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The Strategy offered only a limited absolute protection between September 2007 and March 2009 because equities never reached the overvaluation level that would have triggered the sale of all equities during much of the bear market, unlike in other cycles. The market collapsed mainly because of the Financial Crisis and the subsequent profit debacle.

Nonetheless, the Strategy returned to a fully invested position in late 2008 and remained such through April 2016 even though equity markets more than tripled. The Strategy triggered a 100% cash position in January 2018 and returned to a 100% equity position at the end of December 2018.

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BEWARE DECLINING FAIR VALUES

The Rule of 20 enables us to constantly calculate a “Fair Value” for the S&P 500 Index where FV = [(20 – Inflation) X Trailing EPS]. Fair Value is the Index level at the equilibrium between valuation upside and valuation downside. This FV fluctuates positively with trailing earnings and negatively with inflation and has a 97.5% correlation with the S&P 500 Index since 1957.

A rising Fair Value provides equity markets with an improving fundamental underpinning, mitigating downside stemming from deteriorating sentiment. Conversely, a declining Fair Value accentuates risk until reversed either by an eventual upturn in earnings or a decline in inflation. A declining Fair Value is particularly dangerous for equities.

The Strategy incorporates trends in Fair Value so that initially recommended cash levels are increased if and when Fair Value is in a negative trend phase (cash is capped at 100% to avoid short positions).

GOING FORWARD

I have always been wary of “models” showing their prowess using back data. I trust this Rule of 20 Strategy is rational and sound enough to deliver its promises in the future but nothing beats the real life testing. I have thus set up an investment in a tax free account in which I have invested in a low cost ETF of the S&P 500 Index with a Dividend Reinvestment Plan. I will trade this ETF exactly as the Strategy dictates, starting with the initial investment at the close on Dec. 24, 2018 when the Strategy triggered a 100% equity component. I will be dutifully following the Strategy and track the results.

Data sources:

  • S&P 500 price and total return data: Capital IQ, Yahoo Finance.
  • Inflation data: bls.gov
  • Earnings data: Capital IQ, Refinitiv/IBES.

THE DAILY EDGE (3 August 2018):

Ross Signals More Tariff Pain Ahead in China Trade Battle

Commerce Secretary Wilbur Ross signaled there’s more pain ahead unless China changes its economic system, as the Asian nation repeated it will never surrender to U.S. trade threats.

“We have to create a situation where it’s more painful for them to continue their bad practices than it is to reform,” Ross said in an interview on Fox Business Network on Thursday. The U.S. will keep turning up the pressure on China for as long as the country refuses to level the economic playing field, said Ross.

“The reason for the tariffs to begin with was to try and convince the Chinese to modify their behavior. Instead they have been retaliating. So the president now feels that it’s potentially time to put more pressure on, in order to modify their behavior,” he said. (…)

“China is fully prepared and will have to retaliate to defend the nation’s dignity and the interests of the people, defend free trade and the multilateral system, and defend the common interests of all countries,” China’s Ministry of Commerce said in a statement Thursday on its website. The “carrot-and-stick” tactic won’t work, it said. (…)

Along with its pledge to fight back, China also left the door open for a resumption of negotiations. “China has consistently advocated resolving differences through dialogue, but only on the condition that we treat each other equally and honor our words,” the ministry said.

The U.S. is open to renewing formal negotiations with China, though Beijing must agree to open its markets to more competition and stop retaliating against U.S. trade measures, according to two senior administration officials who briefed reporters Wednesday on the condition of anonymity. (…)

Ross said on Thursday that imposing U.S. tariffs on what would add up to about half of all Chinese imports, which were valued at more than $500 billion last year, won’t cause a major economic upheaval.

A 25 percent levy “on $200 billion, if it comes to pass , is $50 billion a year,” said Ross on Thursday. “$50 billion a year on a $18 trillion economy” is a fraction of a percent, he said, adding “It’s not something that’s going to be cataclysmic.” (…)

  • The RSM has a different math:

The initial costs of the first few rounds of the prolonged trade spat are coming into view. Those costs will be concentrated in a number of critical industrial ecosystems. If the tariff policy is fully implemented, the costs will likely exceed $1.3 trillion with risk of a much greater hit to the U.S. economy than many are currently anticipating, and a premature end to the business cycle.

Euro area economic growth slows at start of third quarter

The pace of euro area economic expansion eased in July, ceding most of the momentum gained in the prior survey month. At 54.3, the final IHS Markit Eurozone PMI® Composite Output Index was down from 54.9 in June and unchanged from the earlier flash estimate.

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The slowdown was mainly centered on the service sector, where growth eased from June’s four-month high. Manufacturing production rose at a slightly faster pace that was broadly similar to that signalled for services activity.

imageNational PMI data pointed to a broad-based expansion of economic output, with growth registered in all of the countries covered by the survey. The rate of increase in Germany improved to a four-month high, whereas growth slowed in France (two-month low), Italy (two-month low), Spain (56-month low) and Ireland (four-month low).

The principal factor underlying slower output growth was a weaker expansion in new work received. New business growth was the second-slowest in over one-and-a-half years. Only Germany saw its rate of expansion improve. Alongside weaker growth of new order intakes, reduced optimism about future business performance also contributed to the generally subdued picture. Although companies continued to forecast that economic activity would (on average) be higher in one year’s time, the overall degree of positivity dipped to a 20-month low. Confidence improved slightly in Germany and France, but dipped in Italy, Spain and Ireland. (…)

July saw a modest easing in price pressures. That said, rates of inflation in output charges and input costs remained elevated and above their respective long-run averages. Input price rises were linked to rising fuel and other oil-related cost increases, which a number of companies passed on to their clients.

The final IHS Markit Eurozone PMI® Services Business Activity Index posted 54.2 in July, down from June’s four-month high of 55.2 and below the earlier flash estimate of 54.4. It was the second lowest reading during the past year-and-a-half. (…)

If the headline index continues to track at its current level, quarterly GDP growth over the third quarter as a whole would be little-changed from the softer-than expected expansion of 0.3% signalled by official Eurostat data for quarter two.

The outlook seems to be turning into a straight choice between the upturn being sustained at its current subdued pace or rising headwinds reining in growth further during the months ahead. On this front, downside risks are more prevalent, as the slower expansion in new order inflows during July was partnered by a tandem dip in business optimism to a 20-month low. Both are reflecting the uncertainty about global market conditions, especially given the ongoing rhetoric about trade wars and the potential spillover effects to the broader economy and to manufacturing in particular.

Improved domestic demand may offset some of this in the near-term, but will need to strengthen further if it is to maintain that role. The faster growth seen in Germany, if sustained, should also help in this regard, especially if it can aid in reversing the weaker expansions seen in its eurozone partners such as France, Italy and Spain during July. However, given rising signs of slowdown and the current uncertain outlook, the ECB will likely maintain its cautious approach to policy at present.”

Chinese business activity expands at slower rate in July

Business activity growth across China slowed at the start of the third quarter, according to the latest Caixin China Composite PMI™ data (which covers both manufacturing and services). This was shown by the Composite Output Index falling from 53.0 in June to 52.3 in July.

The slowdown in overall growth momentum was broad-based, with both manufacturers and service providers in China registering weaker increases in activity in the latest survey period. Notably, service sector output rose at the slowest rate for four months in July, as illustrated by the seasonally adjusted Caixin China General Services Business Activity Index falling from 53.9 in June to 52.8. Meanwhile, manufacturing production rose only modestly.

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Growth in new orders also softened across both monitored sectors in July, most notably across the service sector. Furthermore, the latest increase in new business placed with service providers was the weakest recorded for just over two-and-a-half years and modest. According to panellists, relatively subdued market conditions had contributed to the slower rise in new orders. At the same time, new business received by manufacturers rose at the softest pace since April. Consequently, new work at the composite level increased at the slowest rate for just over a year.

Chinese services companies continued to add to their payroll numbers during July. However, in line with the trend for business activity, the rate of job creation softened since June and was only slight. Employment across China’s manufacturing sector remained on a downward trend at the start of the second half of 2018, though the rate of job shedding eased slightly from June. At the composite level, workforce numbers fell for the second month in a row, albeit marginally.

Higher staffing levels and increased efforts to clear unfinished workloads led to a further decline in outstanding business at services companies in July. Though slight, the rate of backlog depletion was the quickest recorded since the start of 2016. In contrast, capacity pressures persisted at goods producers, as highlighted by a further rise in the level of work-in-hand at manufacturing companies. Overall, outstanding business rose at the weakest rate since September 2017.

Average input costs continued to rise across both the manufacturing and service sectors in July, with the former noting the sharper rate of growth. The increase in input costs faced by goods producers remained steep, despite the rate of inflation easing since June. Meanwhile, services companies registered a strong rise in operating expenses that was generally linked to higher fuel and raw material prices, alongside greater salary costs.

As was the case for input costs, output charges rose across both monitored sectors at the start of the third quarter. That said, manufacturers raised their selling prices at the slowest pace for three months, while services companies increased their charges at the joint-weakest rate since September 2017. Overall, output prices rose at the softest pace since the start of the year.

July survey data signalled a marked deterioration in optimism among services companies, with the level of positive sentiment edging down to the joint-lowest on record. Confidence at manufacturers was meanwhile little-changed from June, remaining historically subdued. At the composite level, optimism towards the year-ahead outlook for business activity fell to the lowest level in 32 months.

Secular inflation?

From Richard Berstein, Chief Executive and Chief Investment Officer, Richard Bernstein Advisors:

We’re not wild about these types of charts, but Chart 4 compares the current cycle’s inflation with the secular period of inflation from the 60s and 70s. We are not showing this chart to suggest that inflation will follow a definitive pattern. Rather, we show it to demonstrate how benignly one of the worst inflationary periods in US history started. That might be worth considering simply because investors remain quite sanguine about inflation given the economic and policy backdrop. (http://www.rbadvisors.com/images/pdfs/Overheating_Ahead.pdf).

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EARNINGS WATCH

380 companies in, 80% beat rate and +5.1% surprise factor. Q2 EPS now seen up 23.6%, from up 20.7% July 1 and +22.9% July 31.

Trailing EPS now $148.05 or $152.40 pro forma the tax reform for 12 months.

Thomson Reuters published its first tally of corporate pre-announcements for Q3, the first warning that the positive momentum may be ending: there are more pre-announcements and they are slightly more skewed towards the negative side than at the same time in 3Q17 and 2Q18.

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Contact: edgeandodds [at] gmail.com