Rule of 20: Why This Stock Market Drop Is a Buying Opportunity

 

An all-time bad day for the market spells an all-time good opportunity for investors

By LUKE LANGO, InvestorPlace Contributor

 

 

The stock market just had a historically bad day. Like all-time bad.

The Dow Jones Industrial Average just posted its biggest one-day drop in history by falling nearly 1,200 points (it was down nearly 1,600 at one point, also an all-time high). The S&P 500 turned negative on the year after falling more than 4%. Even the mighty NASDAQ-100, which represents seemingly unstoppable tech giants like Facebook Inc (NASDAQ:FB) and Amazon.com, Inc. (NASDAQ:AMZN), dropped nearly 4%.

 

Time to sell everything and call it a year? Try again in 2019?

 

I don’t think so. Markets are already rebounding some. And I think there is more upside to come. Here’s why.

 

Why Did the Market Drop?

 

Everyone is throwing their opinion around as to why the stock market decided to drop so much in such a quick manner.

The Fed did come down hard on Wells Fargo & Co (NYSE:WFC), one of the world’s largest banks. That didn’t help things. The stock market was coming off a record start to 2018 and had gone more than a year without a 5% pullback. That is unheard of, so we were due for a reset. Moreover, valuations on equities had stretched to near all-time highs, bested only by the dot com bubble of 2000.

 

But those were all tangential reasons. The big, bad meanie behind this stock market sell-off? Inflation.

 

This big, multi-day correction all started with the January Jobs Report, which showed near-decade high wage growth of 2.9% year-on-year. That spooked investors, because it showed that inflation was showing up in this economy before the effects of tax cuts and Trump’s fiscal stimulus fully materialized. In other words, investors were afraid that the Trump administration was hitting the accelerator on an already heating up economy.

 

What does all that result in?

 

More inflation, which means more rate hikes, which means higher fixed income yields. That is no good for equities. Higher yields on fixed income instruments, like Treasuries, means a lower equity risk premium (the spread between the forward earnings yield and Treasury yields). The lower the risk premium, the less attractive stocks look.

 

This is exactly what happened. Over the past several years, as stocks dropped, so did rates. That allowed for the “buy the dip” mentality to work, because as stocks dropped, the earnings yield got bigger and the equity risk premium got bigger, thanks to falling rates.

 

But as stocks were falling last week and in early Monday trade, rates didn’t go down. They went up. “Buy the dip” didn’t work because as stocks were falling, the equity risk premium was actually getting squeezed by Treasury yields that were shooting higher.

Essentially, then, this recent correction is just a repricing. Stocks are repricing for an era of higher inflation and higher rates.

 

Will the Market Rebound?

 

Yes. The timing of the rebound remains uncertain, but this market is now fundamentally undervalued.

 

When it comes to higher inflation and higher rates, it is important to remember an old school rule in the market called the Rule of 20. The Rule of 20 states that stocks are fairly valued when the forward price-to-earnings multiple plus the inflation rate equals 20. Below 20, stocks are undervalued. Above 20, stocks are overvalued.

 

This rule has worked quite well as a gauge for equity valuation for a long, long time. Academic work shows that a Rule of 20 strategy significantly outperformed a buy-and-hold strategy since 1935.

 

The Rule of 20 also would’ve predicted this sell-off. According to data from Yardeni, the forward price-to-earnings multiple plus the CPI inflation rate consistently broke above 20 recently for the first time since the dot com bubble. In other words, stocks finally got ahead of themselves thanks to surging rates.

 

But now that stocks and rates have come down during this sell-off, we are now well below 20. Forward earnings estimates for the S&P 500 are $156.77. The S&P 500 trades at $2,625 as of this writing, giving the market a forward multiple of 16.74. According to the Philly Fed Survey, the CPI inflation rate over the next 10 years is expected to be 2.35%. Add those two together, and you get to 19.09.

 

In order to get to 20 with a CPI inflation rate of 2.35%, that would imply a forward multiple of 17.65, which on $156.77 forward earnings estimates, would yield a current S&P 500 fair value estimate of $2,767 (5%-plus upside). Then earnings would drive the rest of the growth. S&P 500 earnings are expected to grow around 15% per year over the next five years, implying that even without multiple expansion, the market can rally 15%-per-year over the next five years.

Broadly speaking, the numbers make me bullish on this dip.

 

It’s also worth noting that this whole sell-off was sparked by 2.9% wage growth in the January Jobs Report. While that was the best mark since 2009, we were at 2.8% wage growth in September 2017 and July 2016 (just 10 basis points lower, so essentially a rounding error). Both times, wage growth normalized back down over the next several months to the mid-2% range.

It could do the same thing this time. And if we get a mid-2% or lower rise in wages in February, all these fears might go away rather quickly.

 

Bottom Line On This Stock Market Sell-Off

 

Don’t buy the dip right away. Psychologically, its scary out there right now. The market can’t decide if it wants to rebound or keep selling off after a historically bad Monday.

But once there are signs of market stabilization, I think that is when you want to buy into this beaten up market. Its fundamentally undervalued.

 

As of this writing, Luke Lango was long AMZN and FB.

 

Data from the Internet - SNUMA WM - February 9, 2018