DEEP INTO THE TWILIGHT ZONE

At 2350, the S&P 500 Index is selling at 19.8 times trailing EPS and 18.1 times 2017 estimates of $130. These two charts illustrate how uncomfortable these ratios are from a risk/reward viewpoint.

Using the Rule of 20, which incorporates inflation in the valuation equation, we get a Rule of 20 P/E of 22.1 on trailing earnings. The first chart below shows that the 22 level was exceeded in each of the last 4 bull markets (23.1 in August 1987, 24.7 in Dec. 1991, 31.0 during the internet bubble and 24.2 in June 2008). The only time investors did not end up getting creamed was in the 1992-93 period when inflation was decelerating and earnings exploded 45%, allowing valuations to decline back to fair value range while the S&P 500 marked time for almost 2 years. A very rare equities soft landing.

Before 1987, a Rule of 20 P/E of 22 generally set the peak:

Another way to look at the Rule of 20 valuation chart is to plot the gap between the level of the S&P 500 and the Rule of 20 Fair Value which is simply [trailing EPS x (20 minus inflation)]. The percentage difference between the blue and red lines is the valuation gap given prevailing inflation rates. Equities would thus need to decline 10.8% to return to “Fair Value” per the Rule of 20 (2100).

Let’s declutter the chart further: the +15% to –15% historical gap range becomes very obvious.

Since 1966, in the 6 and 12 months after the Rule of 20 P/E was between 22.0 and 24.9, equities returned –2.2% and –1.0% on average (excluding the internet bubble years) with a range of +19% – (43%) for the 6-month period (45% negative) and +17% – (37%) for the 12-month period (35% negative).

Equities can keep rising from here but the downside risk and potential (eventual) damage rise along and get increasingly disproportionate to the upside potential. In other words, potential gains are being increasingly dwarfed by the downside risk.

Now you can rationally manage your risk.

This is the twilight zone and as Wikipedia puts it:

The episodes are in various genres, including psychological horror, fantasy, science fiction, suspense, and psychological thriller; and often conclude with a macabre or unexpected twist, and usually with a moral.

The coming episodes will no doubt include some, or all, of these elements:

• Will Trump deliver? How much? When?
• Winners? Losers?
• Deficit?
• Trade wars?
• Inflation?
• Interest rates?

Plus the always possible appearances of black swans or other bizarre creatures, known or unknown. Donald Rumsfeld was unknowingly prescient when he said

There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.

Given all the comparisons with the Reagan era, it may be instructive to know that The Rule of 20 P/E was 22.2 in November 1980. Earnings rose another 4% during 1981 before dropping 16% in 1982 while inflation decelerated sharply from 12.7% to 9% on its way to 6.4% at the market trough in July 1982 after a Fed-induced 24% bear market (Fed funds rates reached 19.1% in June 1981) brought the Rule of 20 P/E down to 14.1. High valuations and Fed action will always trump government actions and/or promises.

We never know the future but we sure always know valuations if using trailing data. Given his bold and strong promises, President Trump has an obligation to deliver amid numerous headwinds, some he knows but most he seems unaware of. But even if he succeeds in implementing his policies, much is already factored in valuations at current extraordinarily low interest rates? If Trump delivers, interest rates will likely rise (see on this: EQUITIES AFTER FIRST RATE HIKES: THE CHARTS SINCE 1954 and RISING LONG-TERM RATES: THE SCARY FACTS!). If he does not, all the hope built in equity prices since Nov. 8 will deflate.

BTW, if you don’t care about the Rule of 20, however simple and useful it has been, here’s the record for equities after the even simpler (but less useful) P/E ratio reaches 20. Note that the post-20 average has been meaningfully influenced by the long internet bubble which contributes 25% of the data between 22.0 and 24.9: