Inflation & the Rule of 20 \ C.J. Lawrence Blog
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C.J. Lawrence Weekly – “Inflation & the Rule of 20” – September 18, 2017

C.J. Lawrence Weekly – “Inflation & the Rule of 20” – September 18, 2017

Higher gas prices and housing costs helped push last month’s Consumer Price Index (CPI) reading to 0.4%, versus the 0.3% most economists were expecting.  Interestingly, it was the medical cost category that restrained the index, growing at the slowest pace since 1965, according to the U.S. Bureau of Labor Statistics.  The higher-than-expected result helped raise the annual CPI rate to 1.9%.  That was welcome news for inflation seekers, but domestic inflation remains at historically low levels and below the Federal Reserve’s 2.0% target.  The U.S. 10-Year Treasury Bond responded to the report by tacking on 15 basis points of yield, finishing the week at 2.20%.

The rate of inflation is watched closely by equity investors.  In the early 1980’s, C.J. Lawrence Investment Strategist, and our current Chairman, Jim Moltz, pioneered the CJL Rule of 20 as a measuring stick for the relationship between the market multiple and inflation.  The simple calculation behind the Rule suggested that the sum of the S&P 500 price-earnings multiple and the annual rate of inflation should equal about 20.  The premise suggested that so long as inflation remains tame, the market multiple can climb and remain elevated.  Using Factset consensus S&P 500 earnings per share forecasts of $131 for 2017, and $145 for 2018, and a 2.0% CPI estimate, puts the current reading between 21.2 and 19.3, with a midpoint of 20.3.  That sounds about right.

The current result suggests that the market is certainly not undervalued, but that the valuation is also not stretched beyond historical norms.  In 25 out of the last 50 years, the ratio has held between 19 and 22.  Out of those 25 periods, only three experienced negative equity returns.  Two of those periods were the 1973-1974 period when the S&P 500 returned -14% and -37% consecutively in the bear market of the early 1970’s.  The other negative return period was 2008, at the onset of the credit crisis and subsequent recession.  The average return for the full 25 periods was 9.5%.  There are plenty of risks to equity prices, but the current market multiple, given the historical relationship with inflation, does not look to be close to the top of the list.

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