A good rule of thumb for valuing the market

Holland_F_150x150Tim Holland, CFA, Senior Vice President, Global Investment Strategist

Coming into 2019, Brinker Capital believed if we could solve for monetary policy risk and trade policy risk that the economy and markets would be biased higher. Well, so far, we’ve received more good news than bad on both fronts, and risk assets and the economy have responded, with the S&P 500 Index (S&P 500) up about 17% year-to-date (see chart below) and the US economy growing a much better than expected 3.2% in Q1 – though that number is likely to be revised over time. Having written that, the robust market rally to begin the year has many investors wondering whether stocks can move higher from here.

SP 500 YTD 2019

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 below; the caveat being The Rule doesn’t prove relevant during periods of deflation). And once we have the P/E ratio, we multiply by expected earnings to arrive at a price target for the index, and in turn, the broader market.

Sp 500 average trailling pe

Well, inflation – as measured by the Consumer Price Index – is running at 2%, and Wall Street expects earnings for the S&P 500 on a forward four quarter basis to total approximately $172. So, an 18 P/E ratio on $172 produces a price target of 3,100 for the S&P 500 and additional gains, from today’s price, of about 6.0%.

We remain optimistic on US equities as we move forward into 2019.

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