What Does The 'Rule Of 20' Say About Current Stock Prices?
After a strong close to trading last week, the S&P 500 is once again nearing all-time highs. The six-year bull market that followed the Financial Crisis has been good to many investors.
One of the most traditional ways of valuing the stock market is by using the price to earnings ratio (PE). The S&P 500's current PE ratio is 20.7, much higher than its historical long-term average of 15.5. The S&P’s PE is currently sitting at its highest point since 2009.
In terms of the future, the S&P 500's projected forward PE is currently 16.8, lower than its trailing 12-month PE, but still higher than its long-term average of 13.7.
A look at Nobel Prize-winning economist Robert Shiller's inflation-adjusted CAPE ratio also indicates that the market currently has an extremely high valuation compared to historical share prices. At 27.4, CAPE has only been this high three other times in history: prior to the Great Depression, prior to the bursting of the dot-com bubble and prior to the recent Financial Crisis.
Rule of 20
Finally, one old-fashioned rule of thumb when it comes to market valuations is the Rule of 20. According to the rule, stocks are fairly valued when the sum of the stock market's PE and the U.S. inflation rate is equal to 20.
According to the Rule of 20, the sum of the aforementioned 20.7 PE of the S&P 500 and most recently reported U.S. inflation rate of -0.1 gives 20.6, slightly above the 20.0 fair value level.
While these three quick ways of looking at the stock market value indicate that stocks could currently be overpriced, they are only three out of a countless number of formulas used to value the stock market.
And of course, it always helps to remember: the true value of a stock at any given time is exactly what market buyers are willing to pay for it.
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