Fortunately, there’s no rule about not talking about “The Rule of 20”
Coming into 2019, Brinker Capital believed if we could solve for monetary policy risk and trade policy risk that the economy and the markets would be biased higher. Well, we received more good news than bad on both fronts lately, and risk assets and the economy have responded, with the S&P 500 Index (S&P 500) up about 19% YTD and the US economy growing a better than expected 3.2% in Q1 (though the pace of economic growth likely slowed in the second quarter). Having written that, the very strong first half stock market rally has many investors wondering whether US equities can move higher from here.
One way to think about market valuation and potential price appreciation is via “The Rule Of 20.” Simply put, The Rule Of 20 states a reasonable multiple for the market can be determined by deducting the rate of inflation from the number 20. The reason The Rule carries weight on Wall Street is historically the market’s P/E Ratio (i.e. multiple) has more or less followed the formula (see the chart below); the caveat being The Rule doesn’t prove relevant during periods of deflation. Once we have the P/E ratio, we simply multiply by expected earnings to arrive at a price target for the index (and in turn, the broader market).
Well, inflation – as measured by the Consumer Price Index – is running just below 2%, and Wall Street expects earnings for the S&P 500 on a forward four quarter basis to total approximately $175. So, an 18 P/E ratio on $175 produces a price target of 3,150 for the S&P 500 and additional gains, from today’s price, of about 6.0%.
If we solve for monetary policy risk and trade policy risk, and we think we will, US equities should continue to move higher into year end.
The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Brinker Capital, Inc., a registered investment advisor.
Chart source: FactSet
Tagged: Tim Holland, weekly wire, Rule of 20, S&P 500, market perspectives