July 16, 2020
The Rule of 20 Strategy moved to a 100% cash position as trailing S&P 500 EPS dropped abruptly as Q2 results started coming in pushing the Rule of 20 P/E to 24.2 at yesterday’s opening.
We have reached “extreme risk” levels on equity valuation (black line) while the R20 Fair Value [(20 – inflation) X trailing EPS] (yellow line) is in a clear downtrend as EPS are falling faster than inflation.
The current environment is one of extreme valuation risk accompanied by deteriorating fundamentals. Either investors are totally oblivious to very negative basic equity parameters or they believe the current environment is unusual and/or temporary and valuations do not reflect intrinsic values and better upcoming earnings.
My sense is that both beliefs are in play: expectations of a “V” shape recovery and the desire not to miss this other “don’t fight the Fed opportunity” by inexperienced and momentum-driven people. When the economic expectations will prove wrong, the ensuing decline in valuations will be exacerbated by the crowd’s quick return to earth. Equity markets have this habit of declining much faster than they climb.
This chart shows periods when the Rule of 20 Strategy was all cash since 1957 (black line = R20 P/E). This truly is a “buy low/sell high” strategy.
Since 1957, after the R20 Strategy dictated a 100% cash position, the S&P 500 Index offered negative returns to the next valuation cycle low 7 out of 9 times, shielding investors from severe losses averaging 23%.
The Strategy was all cash during the dot.com bubble keeping investors out of this highly speculative, “irrational exuberance” period.
The only period when the Strategy really failed was between March 1991 and December 1994. However, the S&P 500 was unchanged until November 1991 while earnings declined 12%. EPS then surged 63% during the following 3 years while inflation declined 150 basis points, providing a sharp boost to the Rule of 20 Fair Value which skyrocketed 83% during the period. Overvalued equities were supported by the strong backwind provided by a sharply rising R20 Fair Value. Not quite the case now.
NORMALIZING THE ABNORMAL
This is not a normal, Fed-induced, recession and the economy and financial markets are being strongly supported by governments and central banks around the world. There is thus a case for normalizing earnings. However, there are no rules for that nor are there any precedents to help us assess what “normal” profits will be post pandemic.
- First, we do not know how it will evolve and when it will end (timing issue).
- Second, we do not know what the economy will be like and how corporate America will look like when it eventually ends (revenue/margins issue).
- Third, we do not know how the gigantic economic and financial support will be paid for (growth/taxation issue).
One way out is to calculate what earnings need to be for equities to trade at Fair Value which, in the Rule of 20, is arrived at by multiplying trailing EPS by (20 minus inflation).
If we assume inflation is 1.0% (1.2% in June), fair P/E would be 19.0. At 3220, we would need $169.50 in EPS to be at Fair Value. Current forward 12-month estimates are $143 but full year 2021 earnings are forecast to reach $163, essentially back to their 2018-2019 level.
On that basis, one could argue that equities are close to being fairly valued based on normalized earnings and that a large cash exposure is not warranted. Counter arguments are:
- Any estimate currently is only based on hope that the world will return to normal early in 2021.
- Most companies are unable to provide guidance given the uncertainty.
- In a normal world, with normal growth, normal corporate guidance, forward estimates almost always prove too high, by some 10-15% in general.
- The post pandemic world will be nothing close to normal (see THE DAY AFTER…).
- The coming U.S. elections could materially change the financial outlook, particularly with respect to taxation.
In addition to the earnings risk, the assumption that equities will settle at Fair Value is not supported by history. The Rule of 20 P/E always over-correct one way or the other so it is safer to assume that the valuation downside risk is for the R20 P/E to cycle back to between 17 and 19 which, at 1% inflation, means a P/E of 16.0-18.0. Applied to the $169 low-probability estimate, we get a range of 2700-3050 for a 6-16% downside risk on not-very-solid earnings estimates.
WHAT ABOUT TINA?
Another argument in favor of high equity valuations is the abnormally low level of interest rates. The argument is that low interest (discount) rates boost the value of future cash flows while simultaneously keeping people invested in equities since There Is No Alternative. Counter arguments are:
- The discount rate is also a function of the probabilities of achieving estimated cash flows. Any mid-to-long term forecasts at this time is subject to abnormally wide error factors which should tend to keep discount rates higher than normal.
- If interest rates are abnormally low, it must have a little to do with the fact that growth is also abnormally low. If interest rates stay lower for longer, as the argument goes, they will probably reflect a slower for longer economic growth environment. Expectations for slower economic growth should normally translate into lower earnings growth and lower earnings multiples.
- There have been periods of abnormally low interest rates before. These have not translated into higher equity valuation, at least per the Rule of 20 which very rarely exceeds 24.0.
WHAT ABOUT TECHNOLOGY STOCKS?
The increasing importance (weight) of technology and other acronym stocks in equity indices such as the S&P 500 Index suggests to some investors/strategists that equity markets are justified trading at higher multiples. Yes, but
- These companies are growing fast because their superior technology enables them to grow faster than incumbents. The corollary is that these incumbents are growing at a rate slower than their historical growth rate which normally results in a lower multiple for these stocks that are still populating equity indices. If Amazon grows so fast gaining market share, its losing competitors are effectively slowing down and their stocks should attract lower valuations as a result.
- One could argue that as incumbents disappear (and many will during the pandemic), growth will accelerate for the survivors. If the world returns to normal, that may be so for a short period but once all the weak companies are gone, overall growth has not changed and competition has effectively intensified among the remaining stronger players.
- Maybe tech and acronym stocks are also overvalued as suggested by this chart from Ed Yardeni. Note that Ed uses forward earnings here:
- Lastly, there have also been periods in the past when some sectors gained importance in equity indices as a result of their growth and rising domination. Yet, the range in the Rule of 20 P/E has been remarkably constant between 16 and 24 over time.
The Rule of 20 Strategy is not investment advice. It only serves to help us objectively assess valuation risk vs reward. It makes no forecast, only using trailing earnings and current inflation rates, applied on the historical norm that the Rule of 20 P/E normally fluctuates between 16 and 24 with 20 being the norm for Fair Value.
In this hopefully abnormal world, even normalizing earnings and multiples carries abnormal risks.
Once on “Cheers!”:
Sam: “Beer, Norm?”
Norm: “Have I gotten that predictable? Good.