Everyone would like to predict a market crash and today we will see why, whether it is possible or not and how difficult it is.
We will basically analyze 3 indicators and their pros and cons.
Rule of 20
Peter Lynch managed a fund called the Magellan Fund, which for about 20 years, generated an average compound return 29% annually.
Lynch is also famous for having theorized a very effective formula for understanding whether the stock is overvalued or not. This is called the rule of 20. It consists of taking the price-earnings ratio of the S&P 500 and adding it to inflation. The sum must equal 20. If the result of this sum is greater than twenty the market is overvalued, otherwise it is underrated.
But why 20?
Historically the price-earnings ratio has been 16, US wide, and inflation has been 4%. So the average sum of these two numbers is expected to be around 20%.
The power of this formula is that, by adding up inflation, which is a way of considering the risk of rising interest rates, we can understand when a market is overvalued or undervalued. This is not in relation to historical price-earnings values, but in relation to interest rates.
With this method, you can always figure out what a reasonable price-to-earnings ratio is in relation to current inflation. Clearly these are qualitative indications, we do not expect the market to settle perfectly at the value of 20. It would not make sense.
When the rule of 20 doesn’t work
This rule gives us excellent indications of speculative bubble risk, but it is not perfect as it does not consider monetary policies.
This rule is one of the indicators that we must have in our arsenal, although there are many others that should be considered.
This is a valuation indicator, not a market trend indicator. Valuations are not a tool for making speculative market entries and exits. If something is at a discount it could continue to be at a discount. Also if something is on the bubble tomorrow it could be even more on the bubble.
First let me tell you how we usually measure “overpriceness”: The Shiller PE Ratio, also known as Cyclically Adjusted Price to Earnings ratio, or CAPE 10. Mr Shiller won a Nobel Price with his studies, so of course he deserves our attention.
CAPE is the total market cap divided by the average earnings of the last 10 years, and it’s more accurate than PE.
As you can also see from the link above, high CAPE historically correlates with crashes and recessions.
If it were that simple why don’t they all sell when you exceed a certain value?
well in a period of low rates one expects a higher cape. Also, during bubbles, you never know when you’re high enough to collapse.
So this indicator also has trouble telling us when there is going to be a market crash.
10-year return less 2-year Treasury rate
As you can see from the link above, when the yield difference is negative a recession is followed.
This is because people expect a higher return on 2-year treasury bonds than on 10-year ones.
In practice, people are already expecting a crisis.
unfortunately it does not help us on the timing of the recession.
Indeed often when the recession comes the difference is positive again.
As we have seen, predicting a recession is not impossible, but it could be difficult to understand when it will happen despite the 3 indicators in this post.
However, they can help us understand how to adapt our asset allocation to the historical moment we live in.
We don’t have to anticipate the markets, but we can at least understand when they will arrive.
- Why the Rule of 20 Matter in Stock Valuation
- CAPE Ratio (Shiller PE Ratio): Definition, Formula, Uses, Example
- Inverted Yield Curve: Definition, What It Can Tell Investors, and Examples