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.

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.

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.

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.

• 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.

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.

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.