In this week’s Market Summary, we referred to the Rule of 20.
The Rule of 20 helps assess if the stock market is fairly priced by adding the S&P 500’s P/E ratio to the annual inflation rate. Historically, a total of 20 indicates a fair market value. Currently, this rule can provide insights into whether the market is overpriced or underpriced, aiding in explaining returns to your clients.
Current Market Overview
As of the latest data, the S&P 500's price-to-earnings (P/E) ratio is approximately 23, and the year-over-year Consumer Price Index (CPI) inflation rate is around 3.0%. When these two figures are combined, they result in a value of 26. This is a notable figure because it significantly exceeds the Rule of 20 benchmark, which posits that a total value of 20 suggests a fairly valued market. By surpassing this benchmark, the current combined value of 26 raises concerns about the market's valuation, implying that it may be in an overpriced state.
This elevated value has important implications for investors and advisors. A value of 26, well above the Rule of 20 benchmark, suggests that the stock market may be overvalued, which could signal potential risks for investors. An overvalued market may lead to lower future returns as prices could adjust downward to more sustainable levels.
However, this high value might be due to just one or two sectors.
The Influence of the Technology Sector
The technology sector has been a major driver of the overall P/E ratio of the S&P 500. As of now, the tech sector’s P/E ratio is notably higher than many other sectors, significantly skewing the overall market valuation.
To understand the impact of the technology sector on the current P/E ratio, let’s delve into the specifics:
Technology Sector P/E Ratio: The tech sector’s P/E ratio is approximately 35.
Overall Market P/E Ratio Without Tech: If we exclude the tech sector, the remaining sectors have a combined P/E ratio of around 18.
Rule of 20 Without Technology Stocks
Removing the tech sector from the calculation provides a clearer picture of the valuation of the rest of the market:
P/E Ratio Without Tech: 18
Inflation Rate (CPI): 3.0%
Rule of 20 Value Without Tech: 18 + 3.0 = 21
Without the tech sector, the Rule of 20 value drops closer to 20, suggesting that the non-tech portions of the market are much closer to fair value compared to the overall market, which is heavily influenced by high tech valuations.
Rule of 20 for the 11 Sectors
To provide a comprehensive view, let's break down the Rule of 20 for each of the 11 sectors in the S&P 500:
Communication Services:
P/E Ratio: 18
Rule of 20 Value: 18 + 3.0 = 21
Consumer Discretionary:
P/E Ratio: 27
Rule of 20 Value: 27 + 3.0 = 30
Consumer Staples:
P/E Ratio: 21
Rule of 20 Value: 21 + 3.0 = 24
Energy:
P/E Ratio: 14
Rule of 20 Value: 14 + 3.0 = 17
Financials:
P/E Ratio: 15
Rule of 20 Value: 15 + 3.0 = 18
Health Care:
P/E Ratio: 19
Rule of 20 Value: 19 + 3.0 = 22
Industrials:
P/E Ratio: 21
Rule of 20 Value: 21 + 3.0 = 24
Information Technology:
P/E Ratio: 35
Rule of 20 Value: 35 + 3.0 = 38
Materials:
P/E Ratio: 20
Rule of 20 Value: 20 + 3.0 = 23
Real Estate:
P/E Ratio: 18
Rule of 20 Value: 18 + 3.0 = 21
Utilities:
P/E Ratio: 19
Rule of 20 Value: 19 + 3.0 = 22
Implications for Investment Advisors
Understanding the disproportionate impact of the technology sector on market valuations is crucial for effectively communicating with your clients. Here’s how to shape the narrative around why many investments or strategies may be underperforming if they are not tech sector-driven:
Sector Disparities: Explain that the technology sector's high valuations significantly skew the overall market’s P/E ratio. Investments outside of tech may appear to underperform because they do not benefit from the same level of investor enthusiasm and valuation premiums.
Market Sentiment: Highlight that market sentiment heavily favors technology stocks, which can lead to a perception that non-tech investments are lagging. This preference inflates tech stock prices and can create an illusion of underperformance in other sectors.
Valuation Metrics: Use the Rule of 20 to illustrate that excluding the tech sector, the market’s valuation is closer to fair value. This helps clients understand that their investments in non-tech sectors are not inherently poor choices but are part of a broader, more balanced investment strategy.
Diversification Benefits: Emphasize the importance of diversification. Explain that while technology stocks may drive current market performance, a diversified portfolio can provide more stable returns and reduce risk over the long term. This strategy protects against potential volatility and downturns in the tech sector.
Long-term Perspective: Encourage a long-term investment perspective. Explain that sectors outside of technology often provide steady growth and income, which can be crucial for portfolio stability and achieving financial goals over time.
Potential Corrections: Discuss the possibility of market corrections, particularly in overvalued tech stocks. Explain that a diversified approach can mitigate risks associated with a potential tech sector pullback, ensuring more consistent performance across various market conditions.
By explaining these points, you can help clients see why non-tech investments might seem to be underperforming. This helps them understand the market better and appreciate the importance of having a mix of investments. This balanced strategy aims for growth while managing risks.
Conclusion
The Rule of 20 is a valuable tool for gauging market valuation. Currently, the high P/E ratio of the S&P 500, driven significantly by the technology sector, suggests an overvalued market. However, excluding tech stocks, the market appears closer to fair value.
While the Rule of 20 provides useful insights, it should not be the sole metric for evaluating market valuations. It is essential to consider other factors and metrics to get a comprehensive view of market conditions.
Staying updated with such valuation metrics not only strengthens your advisory role but also ensures that you can provide nuanced and informed guidance to your clients.