Equity valuations should be higher in low-interest-rate, low-inflation environments, but there are limits. The rule of 20 says that equity markets are fairly valued if the price-earnings ratio and year-over-year inflation rate add up to 20 or less.
The rule of 20 also says that Canadian equity investors will face a difficult, negative-return environment in the next two years.
When inflation rates are high, bond yields are also high and more investors are content with risk-free income from government bonds instead of higher-risk, unknowable equity returns. As a result, periods of high inflation are associated with low price-earnings levels for equities. At the beginning of 1990, for example, inflation was running at 5 per cent, the 10-year Government of Canada bond was yielding 9.5 per cent and the equity benchmark was an attractive 14 times trailing earnings.
The chart below shows S&P/TSX performance compared with the rule of 20 for the past 10 years. The grey line shows the forward two-year return for the S&P/TSX composite and the orange line represents the rate of domestic inflation (CPI) added to the equity benchmark price-earnings ratio. Note that the P/E + CPI line is plotted inversely to better show the trend – a rising orange line indicates that the valuations and inflation are falling.
The lines on the chart track closely (the relationship is verified by correlation calculations) which means that future returns on the TSX decline as the combination of P/E ratios and inflation rise.
Inflation data for July, 2016, has not be released, but the final June data point shows that the S&P/TSX composite trailing-price-earnings ratio was 22.5 at that point – well above the 10-year average of 18.2 – and year-over-year inflation was 1.5 per cent. This gives us a rule of 20 reading of 24.
The chart implies that two-year performance calculations from June, 2014, will continue to be negative for the foreseeable future, averaging from zero per cent to negative-10 per cent cumulatively.
It should be noted that the rule of 20, while an effective indicator for the past decade, does not always provide accurate guidance for equity investors. In the period before and after the tech-bubble implosion, it barely worked at all. The rule of 20 should be considered a rule of thumb rather than an ironclad determinant of future equity returns.
Follow Scott Barlow on Twitter @SBarlow_ROB.