Saturday, May 3, 2014

Investing and the Rule of 20

This was recently brought to my attention by a friend and I thought it was an interesting and easy way to think about stock market valuations.  Basically the P/E ratio for the S&P 500 plus the inflation rate gives you a sum that is greater or less than 20.  Above 20 means the stocks are overvalued.  Under 20 and stocks are undervalued.  As of the end of April 2014 this index was 18.5.  

Be sure to use this context.  This is not a short term measure.  It is more of a longer term metric that can be checked every month or quarter.

Below is chart from Bloomberg/Business Week explaining the concept.

Below is a more academic article that basically supports the Rule of 20.  Is it perfect all the time - no.  Does it work a lot of the time - yes.  This could be useful at times when the market seems overvalued.  The article can be found in the Journal of Financial and Strategic Decisions - Fall 1999.  By the way, if you get a chance, looking around on the site can be informative.

These comments are not an endorsement of the Rule of 20.  Please do your own research on this metric.

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