Analyzing the Financial Market: The Rule of 20 In our own unique way, we are all investors. We are definitely all investors in time, but the majority American households also have investments in financial assets, namely stocks. These equity investments can be held in a 401k plan, mutual funds, or an IRA. This doesn’t count the good percentage of people that have a personal account they actively manage or trade.
Divining the direction of the stock market can be as confusing as being a termite in a yo yo. So what would be a good simple gauge we could use to determine if the equity markets are overvalued or undervalued? Price to earning ratio is one determinant, but it has its limitations.
Enter the Rule of 20—a simple formula that has been around for many years but hardly ever used. The Rule of 20 is not a magic formula, but it is useful in evaluating if stock prices are over or undervalued. . What it says is this— from l961 to about l994 the rate of consumer inflation when added to the price earnings ratio (P/E) of the Dow Jones Industrial Average has hovered near 20. The market was overvalued when it was above 20 and undervalued when it was at 15. The formula did not work in the gogo years of l995l999. These five years saw 20% plus gains per year in the popular stock indexes. This was the only time in American financial history we ever saw five consecutive years of 20% plus gains. Painful as it is, we are now returning to a more rational market environment.
What is the Rule signaling now? The current forwardlooking P/E ratio of the Dow is 16. Consumer inflation is about 1.0% annually. This gives a rule of 20 number of 17.0 (Markets are always in a state of flux and you can get the current P/E ratio and consumer price inflation numbers from any major financial publication.)
At a Rule of 20 Number of 17.0, the stock market still has room for upward movement. As stocks rise towards the Rule of 20 number of 20, it may be wise to take some chips off
the table—sell in other words. When stocks fall to a Rule of 20 Number of about 15, think of entering the market by buying good quality equities.
A final note on this Rule. Like any formula devised by mortals, this Rule has its limitations and should not be used in a vacuum. The fundamentals of the company you are buying must also be examined.