Checking Up on the Rule of 20 P/E

P/E ratios are meaningless (in my opinion) unless you know what productivity is doing (which translates into inflation expectations).  It is no surprise that productivity has soared.  It seems simplistic, but it is still hard to beat the "Rule of 20" to determine what P/E's "should" be.

The Rule of 20 P/E is determined by taking 20 (a historical norm) and subtracting the inflation rate, which is at 17.2 today.  We plot this chart daily on our website.  You can see the deviation of the blue line (Forward P/E) and the red line (Rule of 20 P/E).  In normal times, they are very close to each other.  If fear explodes and investors are under-valuing stocks, the blue line is under the red line, and vice versa.  But over time, when emotions and logic returns to normal, the two lines converge.

That is most definitely what is happening today.  You can tell when investor sentiment is changing by measuring the deviation between the two lines.  As you can see, the deviation started converging right after that 2011 correction.

Don Hays

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