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ID-100174766One often asks financial professionals about the direction of the stock market.  While there are many pundits, who are passed off as experts, who will make such predictions, the truth is that one does not really know.  The simple fact is that the best one can do is determining the margin of safety for a particular investment environment.  Given that, there are some wonderful pieces of work that one can use to determine the risks in an investment environment.  The Rule of 20 is one such tool.

Glenn Tanner introduced the Rule of 20 to us in 1999.  To use this rule (R20), one simply adds the average P/E ratio of the S&P 500 to the inflation rate.  If the result is less than 20, the stock market is undervalued, while a result over 20 indicates an overvalued market.  Professor Tanner does warn, however, that using R20 will not guarantee superior results, but does indicate that it can help the individual investor to properly allocate one’s portfolio.

For the development of R20, Tanner uses S&P data from 1935-1999.  Since Fall 1999, though, we have been treated to some wonderful data from Nobel Prize winner Robert Shiller and his publicly shared data for the S&P which spans the years from 1872 to present.  This gives us a lot more data to examine.

Using Shiller’s data, I also sorted the S&P 500 results based on R20.  I then divided the data into quintiles based on R20, and examined the subsequent 12 month results.  The data yielded significant and useful results.  It should be noted that all returns include dividends as part of the return.

First the results based on quintiles:

Quintile Minimum R20 Average Return

Margin of Error (±)

1st Quintile

22.309

2.56%

16.95%

2nd Quintile

19.211

7.54%

17.48%

3rd Quintile

16.130

10.09%

16.86%

4th Quintile

11.858

11.38%

17.89%

5th Quintile

-8.663

12.39%

24.20%

If one needs the significance data, then it is p < .001 (n = 1690) based on Anova analysis.

What this data essentially says is that we will experience below market performance, on average, if R20 is greater than 19.2.  Should we start calling it R19?  Maybe.

There was an attempt to create a regression model, but while the results were significant (p < .05), the correlation was rather weak (r = -.0597).

What does this mean for you as an individual investor?   Currently, the P/E ratio is at 18.98 with an inflation rate of 1.24%.  That gives us a R20 of 20.22, which puts us in a below market average territory.  Dare I say a 3.88% return for 2014?  But that comes with the warning that any prediction has a pretty wide margin of error; 17.48% in this case, so I will not write that in stone.  It does indicate, though, that one needs to find investments that will provide safe harbor if one is very risk adverse.   Perhaps one should take some money off the table if 2013 was very good to you.  Consider limited maturity bonds, and wait for an opportunity if the market turns down.

Good luck this year.  Please remember that there is a difference between buy and hold and buy and forget.

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