The 'Rule of 18' Is Breaking Down

For years, investors used a simple rule of thumb to determine whether the market was cheap or expensive...

It was just a matter of adding the price-to-earnings (P/E) ratio of the market to the current inflation rate. If the number was less than or equal to 18, the market was cheap. If the number was greater than 18, the market was getting expensive.

The "Rule of 18" made intuitive sense for many investors and pundits. The P/E ratio is a classic measure of a company's value. Investors felt confident applying it to the broad market as well.

However, the rate of inflation also has an effect on stock market valuations. At a higher rate of inflation, investors take home less real value by investing in the stock market. In other words, if money is worth less later, why save it instead of use it?

This makes more of a difference than you might think – and it's why the Rule of 18 can't factor in everything that matters to valuation.

In other words, perhaps this simple rule is a little too simple...

The Rule of 18 was bandied about by U.S. wealth managers and economists for many years during the 20th century. As a quick "dipstick" for measuring how hot the economy was getting, it was a useful tool.

Then, in the late 2000s and early 2010s, a new rule came out... It was no longer the Rule of 18, but the "Rule of 20."

The market was considered undervalued if the average market P/E ratio and inflation rate equaled 20 or less. With the market showing signs of strength above the Rule of 18, investors realized they needed to revise the number.

Then, in the late 2010s, as the market continued to rise, investors were quick to call for a correction, since the combined total went above 20 times. We started to hear some calls for a "Rule of 21."

As stocks keep rising, many investors are wondering – rightly – if it's a bit too convenient that the needle keeps moving...

The shifting goalposts might seem like a sign that investors who are always looking to be bullish are just constantly reevaluating the narrative, or that inflation is becoming less important to valuations. In reality, as I noted above, inflation is critical.

Rather, the goalposts keep moving as a result of other factors alongside inflation that affect market values. The old rule of thumb simply can't account for all of them...

For instance, both inflation and taxes have their own effect on the P/E of the market.

Over the past two decades, inflation has been consistently low, thus keeping P/E ratios up. However, the rule has to be adjusted "up" to 21 partly because the simple rule doesn't capture the effect of taxes.

Taxes have been in a secular decline for the past 40 years. As taxes drop, more money goes from a company's net income to investors' pockets. This means shareholders get more bang for their earnings buck, and so they're willing to pay a higher premium.

As you can see in the table below, a lower tax rate leads directly to a higher average P/E ratio, no matter the inflationary context...

Additionally, the simple "P/E ratio plus inflation" relationship of the Rule of 18 (or more) fails to capture the effect of compounding...

Inflation builds on itself, just as higher compound interest in a savings account leads to exponentially higher returns.

If the U.S. experienced 1% inflation for five years, a dollar in 2026 would be worth $0.95 in 2021. Meanwhile, if the U.S. experienced 5% inflation – a small increase – a 2026 dollar would only be worth $0.78 in 2021. At 10%, the 2026 dollar would be worth just $0.62 today.

Due to the compounding effect of any rate over time, as inflation changes, there isn't a linear relationship with the P/E ratio... but an exponential one.

This means a rule of 18 or 20 or 21 will never hold true over a long period of time. Too many other variables determine how cheap or expensive the market is – including taxes, average returns, credit factors, and more.

This is why at Altimetry, we don't just focus on that simple rule, but instead look at things in a broader context. When evaluating market P/Es, we look at both taxes and inflation. When looking at market direction, we also look at credit signals and investor sentiment.

Instead of worrying about what rule of thumb or single metric to use for gauging if the market is undervalued or overvalued, investors should step back... and look at the whole picture.

Regards,

Joel Litman

Editor's note: Joel has a history of uncovering powerful signals – like when he called the March 2020 crash a month early. Now, his research says the vaccine rollout for COVID-19 will crash one specific part of the high-flying tech bull market... and send another group of under-the-radar tech stocks soaring. But you must make the right moves to take advantage of it... Get the full story here.

Further Reading

"Attention to detail is important," Joel writes. "But so is seeing the big picture." Too often, investors can get lost in a company's earnings reports. But the broader view of a business can tell a very different story about its prospects... Read more here: Solving 'Office Myopia' in the Era of the Pandemic.

Finding a company's red flags can be tough to do based on numbers alone. If you want to tell if a business is in trouble, you should start by analyzing the people involved... Get the full story here: To Find Stocks Headed to Zero, Look at the People – Not the Numbers.

Market Notes
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As you can see in today’s chart, ADP shares are rocketing higher. They’re up more than 70% from last year’s lows, and they recently hit a new all-time high. It’s a prime example of why you should invest in the world’s best companies…