What Is The Rule Of 20? The Rule of 20 helps us think about valuations and bull and bear markets. To calculate the Rule Of 20 we combine the P/E ratio and inflation rate. Over the years, markets have shown a distinct tendency to revert to a sum of 20 for these two metrics.
The value of the markets is fair when the sum of the P/E ratio and the inflation rate equals 20.
P/E + Inflation = 20
The stock market is undervalued when the sum is below 20 and overvalued when the sum is above 20.
This seemingly simplified insight is nonetheless surprisingly effective, as noted by Evercore ISI for the Rule of 20.
Markets rarely trade at equilibrium, so it’s no surprise that the Rule of 20 is seldom precise.
The combined P/E ratio and inflation rate have ranged from a low of 14 to a high of 34.
Over the last 50 years, the average P/E is just below 16, the average inflation rate is 4 percent, and the average sum of P/E and inflation, as expected, is close to 20.
The rule peaked at the 2nd highest level in history earlier this year. Such levels suggest the market is more than “fully priced.” Regardless of what definition you choose to use.
Poster Comment:
S&P 500 PE Ratio chart, historic, and current data. Current S&P 500 PE Ratio is 20.50. Is the S&P 500 overvalued right now? We find that the S&P500 is currently trading 43% above its modern-era historical mean, (about 1.2 standard deviations) indicating that the market is Overvalued. CPI is 8.3%. Shadow Stats is 16.8%.