THE RULE OF 20 STRATEGY GOES ALL CASH

December 30, 2019

On December 26, 2018, the Rule of 20 Strategy went 100% equities at 2407 on the S&P 500 Index. One year and +35% higher at 3220, the Rule of 20 Strategy is going 100% cash!

Here are the big moves made by the Rule of 20 Strategy in the past 2 years:

• 100% cash between January and October 2018 when the S&P 500 went from 2823 to 2711 as the Rule of 20 PE went from 23.5 to 19.3.
• 90% equity in October 2018 at 2711, boosted to 100% after the close on December 24, 2018 at 2407 when the Rule of 20 PE dropped to 16.9.
• 70% equity on July 25 at 3000 (R20 PE = 20.5), reduced to 40% on September 13 at 3018 after the Rule of 20 Fair Value 3-month moving average declined.
• 100% cash on December 26 at 3230 as the Rule of 20 P/E reached 22.1 with continued decline in the R20 Fair Value moving average.

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 is a great risk management tool, what the equity investing game is all about.

The Rule of 20 P/E (actual P/E + core inflation) generally nicely cycles 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 long-term 20 mean, equity market cycles are predictable, at least in their valuation trends.

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. (Warren Buffett)

At its current 22.1 level, the rational valuation upside potential is +8.6% (24/22.1) while the valuation downside risk is –27.6% (16/22.1).

Valuation is only one variable, the other one being profits. But S&P 500 trailing earnings are declining. Q3 earnings declined and Q4 earnings are also expected to decline.

One may want to relax based on better earnings prospects for 2020 as analysts currently expect a 9.7% gain but buying expensive equities on forward earnings needs a prayer or two hoping that analysts will prove right, this time…

Ed Yardeni knows prayers are futile on that particular matter.

The other possibility is that inflation slows down meaningfully, potentially providing support to the Rule of 20 P/E. Unfortunately, inflation is also a variable in corporate revenue growth rates and profit margins. This cycle, inflation keeps confounding just about everybody. Meanwhile, business sales growth has slowed to a crawl, pressuring operating margins across the board.

If you wonder how close a relationship exists between Business Sales and S&P 500 revenues, Ed Yardeni has this chart for you:

Here’s the relationship between Business Sales and pretax operating corporate profits:

Holding overvalued equities when profits are declining can prove very costly since we cannot predict how low profits will get and a double whammy (lower profits, lower PE) is highly probable if the earnings decline proves durable.

In truth, the basic Rule of 20 Strategy currently sets equity exposure to 50% at the current 22.1 valuation levels.

But 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 (20). 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 (PE). 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 worst case being the combination of declining profits with rising inflation.

The Strategy incorporates trends in Fair Value so that initially recommended cash levels are increased when Fair Value is in a negative trend phase. Given the current negative trends in FV, the Strategy doubles the cash level set by the basic Strategy.

The Rule of 20 Fair Value (yellow line below) currently stands at 2896, 10.6% below the current S&P 500 Index level (blue), and is declining (it peaked at 2952 at the end of June 2019).

See also THE RULE OF 20: THE HISTORICAL RECORD