Many folks have heard of the Rule of 72 in investing (72 divided by your % investment return equals the # of years to double your investment).  Recently I came across another rule for equity investing that I think has some value.  Developed by Jim Moltz more than 30 years ago, the “Rule of 20” states that the sum of inflation plus the price/earnings ratio of the equity market (as measured by the S&P 500) has averaged right around 20.

When the “Rule of 20” was violated to the upside, as it was significantly in 2000 and 2007, a major decline followed.  Conversely, when the “Rule of 20” was violated significantly to the downside as it was in 1983, a multi-decade climb ensued. (see chart below courtesy of ISI)

Analyst consensus estimates of 2013 earnings for S&P 500 companies is $105.  The S&P 500 index closed on May 30, 2013 at 1,654.41 which means the current Price/Earnings ratio is 15.75.  The Federal Reserve has stated that their inflation target is 2.0 percent, even though its favored inflation gauge, the Personal Consumption Expenditures (PCE) price index, has fallen to a 3-1/2 year low of 1.0 percent.  For arguments sake I will use 2 percent inflation and the current P/E ratio so we get to 17.75.  This would suggest that the equity market still has some room to increase before running into the “Rule of 20”.

There is an interesting dynamic going on in the US right now.  One might call it a positive feedback loop.  Rising stock prices, house prices, and employment are all lifting consumer confidence. Rising stock prices, employment and consumer confidence are all lifting house prices. Rising employment, house prices and consumer confidence are all lifting stock prices.

This all bodes well for the outlook for the economy and equity investments.  However, I am also keeping a close eye on the bond market.  Interest rates, as measured by the US 10-year Treasury, broke over 2% this week to the highest level since March 2012.   I think it is likely that interest rates will continue to creep higher.  Increasing interest rates are a negative in that they increase borrowing costs, particularly for housing, and they hurt equity valuations.  However, rising rates also reflect an improving outlook for the US economy and increasing mortgage rates tend to encourage potential buyers to act, which helps housing & the economy.  [30-year fixed rate mortgages jumped to 3.81% this week (Freddie Mac).  That’s up 15% from the record low of 3.31% set the week of November 21, 2012]

Up to say 3.0% on the US 10-year Treasury I think the positives of increasing interest rates outweigh the negatives.  Rates above that level may be more problematic. This increase in interest rates coincides with a spike in volatility in the equity market.  As measured by the VIX (S&P 500 volatility index), volatility jumped  27% over the last couple of weeks. So far this year equity volatility has been relatively low.  This recent rise could be a short term spike or a shift to more persistent volatility.

I remain on high alert and will closely monitor the markets and economic indicators and will let you know if I think any adjustments to your portfolio are warranted.  In the meantime, please call me if you have any questions or concerns.

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