THE RULE OF 20 VS “REY”

Barron’s interviewed John Apruzzese, chief investment officer of Evercore Wealth Management in its May 7 edition (Who Says This Market Is Overpriced?):

Inflation is absolutely crucial for long-term investors. It’s the most important macro factor. Oddly, the market is stuck on the P/E ratio. When people talk about Treasuries, they don’t say that if a bond yields 2%, it is selling for 50 times the coupon. It’s upside-down. The conventional way of saying inflation is important is the Rule of 20, which is that the P/E plus inflation should equal 20. Why is that? It makes much more sense to think about the earnings yield than to use a reciprocal. Once you do that, it falls into place. You can take the earnings yield and subtract inflation and that’s the real earnings yield. (…)

That’s significant because people are looking at the CAPE [cylically adjusted P/E] ratio, which looks really expensive using the average of the past 10 years. Of course it does, because it includes 2008 and 2009. As soon as that rolls forward, the P/E falls. On the other hand, people might say the P/E isn’t that expensive relative to low bond yields. Inflation is related to bond yields, but bond yields are artificially low. For example, the 10-year Treasury should nominally yield GDP [gross domestic product] and be at 4%. But it doesn’t because it has been manipulated by the central bank. When bond yields return to normal, people will have lost the justification for the current P/E.

Today, on the real earnings yield, the market is almost exactly at its long-term average. (…)

“John has always focused on the core issues in investing,” says Ed Yardeni, chief of Yardeni Associates, another market bull.

Yardeni says that Apruzzese’s study of the real earnings yield “neatly incorporates inflation into a stock-valuation model. It’s a simple model that is easy to construct and comprehend, and it has a good track record.”

Apruzzese explains why he is using the real earnings yield (REY) model [E/P – Inflation] and not the simpler Rule of 20:

At low inflation levels, each percentage point by which the CPI growth rate increases will reduce fair value for stocks by just five percent or so under the Rule of 20.

Say inflation has been running at two percent, much as it has been lately. An increase to four percent would take fair value on stocks from 18 times earnings to 16, but it’s difficult to imagine such a muted reaction to that great a jump in inflation. By contrast, fair value would drop by the same proportion, from nine to eight, if inflation rose from 11% to 12%, even though the markets probably would judge such a move as far less significant than a doubling of inflation in a low-inflation environment.

(…) a more conceptually and mathematically rigorous adjustment that takes full account of inflation would start with the earnings yield instead of the P/E ratio and subtract the inflation rate. (…)

REY provides a full adjustment for inflation, without the distortion that results from subtracting the same change in inflation from different starting rates and therefore different fair values. REY will rise or fall by one percentage point with each decline or increase, respectively, in the inflation rate, no matter what the starting levels of inflation or the nominal earnings yield may be, providing a more accurate assessment of potential returns. (…)

Mathematically sensible (although debatable) but less useful in the real world. Judge by yourself:

The Rule of 20 is much more stable around its 20.0 average with a very useful symmetry around the average allowing for more dependable calculations of risk vs reward which is the ultimate objective.

FYI, here’s Apruzzese’s November 2017 paper A Reality Check for Stock Valuations.

Also FYI, LPL Research produced this chart in its April 30, 2018 Market Commentary. Notice how average P/E ratios plus inflation always total roughly 20.