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It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

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THE DAILY EDGE: 24 JANUARY 2019: Strong USA in Weak World

MARKIT’S FLASH PMIs
U.S. private sector firms report solid start to 2019, helped by faster manufacturing output growth

January’s survey data indicated a solid start to the year for U.S. private sector companies, with output growth maintained at a broadly similar pace to that seen through the final quarter of 2018.

Manufacturing remained a bright spot as production volumes expanded at the fastest pace for eight months. Service providers signalled a sustained upturn in business activity during January, but the rate of growth eased to a four-month low.

At 54.5 in January, up fractionally from 54.4 in December, the seasonally adjusted IHS Markit Flash U.S. Composite PMI Output Index was well above the 50.0 no-change value. The latest reading was close to the average seen over the final quarter of 2018 (54.7) and signalled robust expansion of private sector output at the beginning of 2019.

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Higher levels of business activity were supported by a rebound in new orders growth from the 14-month low seen in December. Survey respondents mostly commented on improving underlying economic conditions and resilient confidence among clients. There were only sporadic reports citing the government shutdown as a factor weighing on demand at the start of 2019.

Stronger new business growth contributed to a marginal increase in backlogs of work at private sector firms in January. However, the rate of staff hiring eased to its weakest since May 2017. Some survey respondents attributed softer employment growth to efforts aimed at improving productivity and streamlining costs.

Input price inflation eased to a 22-month low in January, helped by weaker cost pressures across the service economy. In contrast, manufacturers continued to report sharply rising raw material costs, linked to trade tariffs and stretched domestic supply chains. Average selling prices for goods and services meanwhile rose at a slightly increased rate, although the rate of inflation was the second- weakest seen over the past year.

Looking ahead, business optimism lifted up from December’s one-year low, rising especially sharply in the manufacturing sector, though remained below last year’s average.

The seasonally adjusted IHS Markit Flash U.S. Services PMIâ„¢ Business Activity Index slipped to 54.2 in January from 54.4 in December, but still signalled a solid upturn in service sector output. New business growth remained subdued in comparison to the peaks seen in the first half of 2018. The latest rise in new work was one of the weakest seen in the past year-and-a-half.

Service providers signalled only a modest rebound in business expectations from the 12-month low seen in December. Subdued growth projections for the year ahead contributed to more cautious hiring strategies in January. The latest increase in payroll numbers was the weakest since April 2017.

The main positive development in January was a slowdown in input cost inflation to its lowest for almost two years. Prices charged by service providers also increased at a much slower pace than seen on average in the second half of 2018.

Manufacturing growth regained momentum at the start of 2019, according to the latest survey data. Adjusted for seasonal influences, the IHS Markit Flash U.S. Manufacturing Purchasing Managers’ Index™ (PMI™) rose to 54.9 from 53.8 in December. The improvement in overall business conditions was driven by the fastest expansion of production since May 2018. New orders, employment and stocks of purchases also increased at faster rates in January.

Survey respondents generally cited robust domestic demand, which more than offset a slowdown in export sales growth to its weakest for three months. Moreover, latest data indicated that manufacturers are more confident about the 12-month business outlook than at any time since May 2018.

Stretched supply chains remained a challenge for manufacturers, with vendor lead-times lengthening for the twenty-fifth month running in January. Strong demand for inputs and higher imported raw materials costs related to trade tariffs led to a strong rise in input prices and another robust increase in factory gate charges across the manufacturing sector.

Chris Williamson, Chief Business Economist at IHS Markit:

The resilience of the survey data suggest little impact from the government shutdown on the private sector, with very few companies reporting any material detrimental impact on their output or order books. Historical comparisons suggest January’s survey data are indicative of the economy growing at an annualised rate close to 2.5%. However, as the survey does not include the government sector, the impact of the shutdown may not be fully captured. (…)

The jobs data from the surveys were also somewhat disappointing, with the overall rate of job creation slipping to a 20-month low. However, even this weaker January survey employment index reading is consistent with private sector payroll growth of approximately 150,000. (…)

The apparent resilience of the U.S. economy is further supported by the following observations, although we seem to be on shaky ground:

  • The US Sales Manager Index (SMI) from World Economics shows that business activity is holding up in January. However, business confidence softened, and the pace of hiring (“staffing levels”) slowed substantially. (The Daily Shot)

(…) Major components of the barometer were mixed in January. Trends in construction-related resins, pigments and related performance chemistry were mixed, suggesting slow housing activity. Plastic resins used in packaging and in consumer and institutional applications turned positive, performance chemistry gained, and U.S. exports were mixed. Equity prices retreated sharply again this month, and product and input prices fell as well. Inventory indicators were positive.

The diffusion index was stable at 53 percent. This index marks the number of positive contributors relative to the total number of indicators monitored.

“The CAB continues to signal gains in U.S. commercial and industrial activity through mid-2019, but at a much slower pace as growth (as measured by year-earlier comparisons) has turned over,” said Kevin Swift, chief economist at ACC. “Despite three straight months of decline in the barometer, the cumulative decline is 1.0 percent – well below the 3.0 percent that would signal negative growth in the U.S. economy.”

CalculatedRisk has the chart:

Euro area business growth close to stalling at 5½ year low in January

The euro area economy edged closer to stagnation at the start of 2019, with businesses reporting the weakest rise in output for five-and-a-half years and the first fall in demand for over four years. The IHS Markit Eurozone Composite PMI® fell to 50.7 in January from 51.1 in December, its lowest since July 2013, according to the preliminary ‘flash’ reading. The latest reading indicated only marginal growth of business output, contrasting markedly with the strong rates of expansion seen this time last year.

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Both manufacturing and services saw growth slow closer to stagnation. The factory sector reported the weakest expansion since the current production upturn began in July 2013, while the service sector expansion was the smallest since August 2013. Inflows of new work fell compared to December, registering the first such decline since November 2014 and signalling the largest drop in demand for goods and services since June 2013.

New orders for goods fell for a fourth successive month, declining at a rate not seen since April 2013, while inflows of new business in the service sector slipped into decline for the first time since July 2013.

Deteriorating exports contributed to the disappointing order book picture. Exports fell for a fourth successive month, dropping at the steepest rate since comparable data for combined manufacturing and services exports were first available just over four years ago. Services saw exports decline at an increased rate.

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Outstanding work decreased for the second consecutive month, worsening at the sharpest pace since December 2014. Falling backlogs were commonly caused by companies having to eat into back-orders in order to support current output growth amid reduced inflows of new business.

The decline in order books was a key factor behind a reduction in the pace of overall job creation to the lowest since September 2016. Jobs growth has now cooled for five months in a row. Employment growth waned in both sectors, though services saw an especially marked slowdown.

Looking ahead, future optimism improved slightly during the month, though remained close to recent four-year lows to reflect a gloomier picture than seen throughout much of last year. Company concerns centred on the overall bleaker economic picture developing for the year ahead, often linked to international trade tensions, Brexit and rising political stress, especially in France and Italy but also globally. The weakness of the auto sector also remained a key area of concern.

Analysing trends within the region, businesses in France reported an increased rate of decline, blamed on the combination of disruptions caused by on-going ‘Gilets Jaunes’ protests and a generally weakened demand environment. Output fell in both manufacturing and services, resulting in the largest overall drop in business activity since November 2014. In Germany, output growth picked up compared to December thanks to faster growth in the service sector, but the monthly expansion was still the second-weakest seen over the past four years. The headline manufacturing PMI recorded the first deterioration in business conditions since November 2014, fuelled by the largest falls in factory orders and exports seen since December 2012.

Weakness in the auto industry was once again widely reported, as was a slowdown in demand from China.

Elsewhere, the rate of output growth sank to its lowest since November 2013, slowing to only weak rates in both manufacturing and services. New order growth was likewise the weakest since November 2013, led by the first fall in manufacturing for five-and-a-half years.

Looking at prices, average output charges meanwhile rose at a slightly increased rate, in part due to rising selling prices in Germany associated with increased road toll charges as well as some signs of upward wage pressures. However, there was better news on input cost inflation, which moderated to the lowest for nearly one-and-a-half years. Softer cost inflation principally reflected lower oil prices and easing capacity constraints in supply chains, allowing firms to negotiate lower prices in many instances. The incidence of supplier delays was the lowest for two-and-a-half years. Both input cost and selling price inflation eased in manufacturing but picked up slightly in services.

The Eurozone economy slipped closer to stall speed in January, with companies reporting the first drop in demand for over four years. The disappointing survey data indicate that GDP is rising at a quarterly rate of just 0.1%. (…) Companies are concerned about a wider economic slowdown gathering momentum, with rising political and economic uncertainty increasingly affecting risk appetite and demand.

Flirting with recession. Blackstone is not optimistic:

Eurozone leading economic indicators declined 2.0% year over year in November and the Citi Economic Surprise Index is negative, indicating that data releases have been worse than expected.1 Notably, since the Eurozone’s formation in 1999, every instance of a 2% YoY decline in leading indicators has been followed by a recession or QE

Eurozone Leading Economic Indicators
Eurozone Leading Economic Indicators

Nor is NBF, with caveats:

The zone’s industrial production seems to have contracted on a year-on-year basis in the final quarter of 2018. The last two times this happened (2008 and 2012), the common currency area eventually fell into recession. Does this latest blotch of red ink on industrial output mean the Eurozone is headed for yet another recession? That possibility cannot be ruled out especially if the deceleration of global trade extends into 2019, social unrest in places such as France and Italy gather momentum and/or Brexit spirals into something worse. But if those can be avoided, the zone has potential to bounce back. There were indeed extraordinary events that hurt Germany’s economic activity in the second half last year, including tougher pollution standards (which hurt auto sales) and an extended drought which affected major waterways (and hence goods transportation) including the crucial Rhine river. More importantly, financial markets are functioning well and allowing credit to flow freely in the Eurozone. As today’s Hot Chart shows, unlike in 2008 and 2012, loans to households and non-financial corporations continue to grow at a healthy clip, which bode well for consumption spending and business investment.

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Gavekal on a broader front:

Alas, most growth indicators look weak: ISM surveys and OECD leading indicators have recently disappointed. Weak points can be seen in the struggling automobile sector, slowing Chinese economy, softening real estate prices in almost every major market and a slashing of capital spending in the energy sector. It is hard to find much, beyond the employment data (a notoriously lagging indicator), to be cheerful about on the growth front.

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Japan manufacturing sector flatlines as demand weakens and production is reduced
  • Flash Japan Manufacturing PMI® falls to 50.0 in January (52.6 – December), ending longest expansionary run for over a decade.
  • Exports decline at strongest pace in two-and-a-half years
  • Production scaled back for first time since July 2016, while confidence lowest in over six years.

Preliminary PMI data for January bodes ill for Japan’s manufacturing sector, indicating the end of a near two-and-a-half-year growth run as the index dropped to 50.0. The underlying picture will raise concern given renewed reductions were seen in new orders and output. Further signs that the downturn in the global trade cycle could yet worsen were also signalled, with new export orders falling at the sharpest rate since July 2016. The widely-anticipated rebound in Q4 should not distract from the bigger picture. Domestic economic weakness compounded with slowing global growth coincided with the lowest level of business confidence for over six years.

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Meanwhile in Canada (via The Daily Shot)

CERTAIN UNCERTAINTIES
Businesses reveal growing uncertainty worldwide

Analysis of survey anecdotal evidence suggests that global business uncertainty spiked higher at the end of 2018 to reach a 22-year survey high. Companies reported heightened political and economic risk and worries about declining exports, according to the PMI survey responses.

IHS Markit’s Purchasing Managers’ Index® (PMI®) surveys are based on monthly questionnaires of carefully selected companies across over 40 countries. Globally, the surveys compile responses from around 28,000 companies monthly. (…)

Panellists across the world have increasingly highlighted uncertainty when predicting their future output in recent months. December recorded the most mentions of the word “uncertainty” from businesses expecting future output to decrease since the series began in July 1996. Moreover, this represented a stark increase from the already high frequency seen throughout the year. (…)

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Analysing individual comments reveal key factors influencing this uncertainty. Broadly, these consist of political tensions, economic worries and the deteriorating international trade environment.

The downturn in trade has been of notable consequence recently, with the frequency of comments rising sharply. Concurrently, the J.P.Morgan Global Manufacturing PMIâ„¢ exports index has signalled a decline in exports for four successive months, prompted by US and Chinese tariffs and slowing output growth.

Panel comments also capture the trends of rising political and economic uncertainty over the course of last year. Mentions of political tension grew to near-peak levels in December, in part due to Brexit and other worries across Europe, but also worldwide political friction.

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EARNINGS WATCH

We now have 76 Q4 reports in and the beat rate is steady at 78% while the surprise factor, currently +2.2%, is more volatile (+1.7% the day before) but holding ok.

Revenue surprises are not quite as strong (61%) but revenue growth for the 76 companies is 6.3% vs an expected 5.8%. Financials account for 38% of reporters so far and their revenues are up only 2.7%.

Refinitiv’s blended growth rate for Q4 is now 14.2% (14.1% yesterday).

Q1’19 growth slipped from +2.7% to +2.6%.

Full year 2019 EPS are $171.04, down from $171.29 yesterday.

We see some potential for more downgrades, although the ERR is nearing past trough levels outside of recessions. U.S. earnings are coming off a “sugar high,” with 2018’s fiscal stimulus and tax cuts setting a high bar to clear. Earnings per share (EPS) of global stocks are expected to grow 6.6% in 2019, versus 14.9% in 2018, according to consensus estimates. (Blackrock)

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SENTIMENT WATCH
Airplane Via David R. Kotok Chairman and Chief Investment Officer, Cumberland Advisors

Air Traffic Controllers, Pilots, Flight Attendants Detail Serious Safety Concerns Due to Shutdown

Washington, D.C. — On Day 33 of the government shutdown, National Air Traffic Controllers Association (NATCA) President Paul Rinaldi, Air Line Pilots Association (ALPA) President Joe DePete, and Association of Flight Attendants-CWA (AFA) President Sara Nelson released the following statement:

“We have a growing concern for the safety and security of our members, our airlines, and the traveling public due to the government shutdown. This is already the longest government shutdown in the history of the United States and there is no end in sight. In our risk averse industry, we cannot even calculate the level of risk currently at play, nor predict the point at which the entire system will break. It is unprecedented.

“Due to the shutdown, air traffic controllers, transportation security officers, safety inspectors, air marshals, federal law enforcement officers, FBI agents, and many other critical workers have been working without pay for over a month. Staffing in our air traffic control facilities is already at a 30-year low and controllers are only able to maintain the system’s efficiency and capacity by working overtime, including 10-hour days and 6-day workweeks at many of our nation’s busiest facilities. Due to the shutdown, the FAA has frozen hiring and shuttered its training academy, so there is no plan in effect to fill the FAA’s critical staffing need. Even if the FAA were hiring, it takes two to four years to become fully facility certified and achieve Certified Professional Controller (CPC) status. Almost 20% of CPCs are eligible to retire today. There are no options to keep these professionals at work without a paycheck when they can no longer afford to support their families. When they elect to retire, the National Airspace System (NAS) will be crippled.

“The situation is changing at a rapid pace. Major airports are already seeing security checkpoint closures, with many more potentially to follow. Safety inspectors and federal cyber security staff are not back on the job at pre-shutdown levels, and those not on furlough are working without pay. Last Saturday, TSA management announced that a growing number of officers cannot come to work due to the financial toll of the shutdown. In addition, we are not confident that system-wide analyses of safety reporting data, which is used to identify and implement corrective actions in order to reduce risks and prevent accidents is 100 percent operational due to reduced FAA resources.

“As union leaders, we find it unconscionable that aviation professionals are being asked to work without pay and in an air safety environment that is deteriorating by the day. To avoid disruption to our aviation system, we urge Congress and the White House to take all necessary steps to end this shutdown immediately.”

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.