After rallying 16% this year, the S&P 500 Index closed last year at its highest point since 2007, as investors celebrated news that central bankers were riding to the world's rescue with yet more stimulus. But is it too far too fast?
The answer is no, according to an old rule-of-thumb. A fundamental market valuation tool called "The Rule of 20" gives a quick-and-dirty picture, and at the moment, the market is undervalued by about 8%, and the fair value of the S&P is 1575. Here's the math: take the price to earnings ratio on the trailing 12-month GAAP (as reported) EPS and add the rate of inflation. If the number is 20, the index is fairly valued. If the number is over 20, the market is too rich, if under 20, it's a bargain.
Sam Stovall, chief equity strategist at S&P Capital IQ, thinks the old rule-of-thumb still works. He noted in a report today that the rolling quarterly "rule of 20" value was a median 19.8 since 1948. Further, the median difference between the actual and implied value of the index was just 1% in that time. Stovall admits the implied value has gyrated over time, notably when the tech bubble burst in the early 2000s. But the movement around the 20 mark has been fairly consistent, he wrote, with nearly 70% of the measurements since 1948 caught the magic number between 15 and 25.
The S&P 500 closed Friday at 1460.26. The P/E on the trailing 12-month GAAP EPS was 16.61. August's Headline CPI was 1.93%. The P/E plus inflation was 18.54, which works out to an undervaluation of 8%. This calculation sets the index's fair value at 1575.
Stovall wrote that the rule of 20 is a fundamental valuation tool that arrives at the same conclusion as both technical tools and history. Mark Arbeter, S&P Capital IQ's chief technical strategist has said for months that the S&P 500 ought to rise to 1500-1600 by next year. On the historical basis, Stovall notes that in the 54 declines of 5ÿ0% since the end of World War II, once the index has regained its lost ground, it has climbed another 8% in the next three months. That's before it dips again by 5% or more. So viewed through the historical lens, this latest rally should push the S&P 500 to 1535.
Whichever metric you choose, it works out to another 5ÿ0% rise before the end of the year. But as always, Stovall notes, past performance is no indication of future results.