3 Investment Rules to Get You Through Uncertain Markets

For the past three months, the Standard & Poor’s 500 has churned sideways. Is that a bad portent? Not at all. The outlook is for higher prices, if you look at three indicators: the relationship between inflation and market value (known as the Rule of 20), the S&P 500’s earnings/price yield, and energetic merger activity.

Yes, stock prices in aggregate have been trendless and choppy. On down days, it feels as if a bear trend may have started. On up days, optimism takes over. This type of market offers active investors an excellent opportunity to overtrade and lose money.

Do not anticipate how the game will end, even if it feels like there are only seconds left on the clock (especially if you are in the last seconds of the Super Bowl). Allow your disciplined, rules-based approach to guide you through the short-term volatility.

1. The Rule of 20

This involves subtracting the current rate of inflation from the number 20 to determine the potential price/earnings of the S&P 500. If inflation is 2% or less, the potential P/E is 18-plus. At an 18 P/E multiple on $125 – the 2015 consensus for S&P 500 earnings – the index could potentially move 10% higher.

Inflation rose 0.2% in January, not counting food and energy. If we substitute that rate in place of the Federal Reserve target rate of 2%, the potential P/E jumps to 19.8, implying roughly 17% potential appreciation from current levels.

In the late 1970s, inflation ranged from 12% to 14% annually. During this time, the S&P 500 P/E was in single digits. The Rule of 20 worked.

Generally, if we assume no deflation, the Rule of 20 implies the market is overvalued if the P/E exceeds 20. At the moment, the S&P’s P/E is 19.

In 2000, the S&P 500 P/E reached 26 with inflation running at an average of 3.4%. A two-and-a-half-year bear market then followed. At the peak in November 2007, inflation was 4.3%. The inflation rate implied a multiple potential for the S&P 500 of 15.7%. This is roughly the maximum P/E level achieved at the high in 2007 before the 2008-2009 bear market.

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Source: iStock

Source: iStock

2. Earnings yield

Another long-term indicator for where the market is headed comes from dividing S&P 500 earnings by its price (E/P) to determine the earnings yield of the market. Since 1963, the S&P 500 average real earnings yield (that’s adjusted for inflation, which we estimate at 1.5% yearly) is 2.5%, according to JP Morgan Asset Management’s Market Insights. On that basis, the index’s current real earnings yield is roughly 4.5%. The S&P 500 would have to increase about 35% to reach its long-term average real yield – meaning the denominator would need to increase that much.

Both the Rule of 20 and the real earnings yield of the S&P 500 suggest the bull market has not yet reached its valuation potential. The implication from these rules is the sideways trading pattern of the market for the past three months could be just a healthy consolidation before another leg higher in this bull cycle.

3. M&A

Meanwhile, company managements give off a bullish sign with their robust plans for mergers and acquisitions. When companies buy other companies, the acquisition should be accretive, meaning the purchase price should be sufficiently low to allow for the future earnings stream to make a good return on investment.

The latest evidence of ebullient M&A activity came when pharma giant Pfizer announced the acquisition of Hospira for $90 per share or $17 billion, roughly a 40% premium over the prior-day closing price.

Pfizer would pay the 40% premium on top of a large run-up for Hospira, the biggest provider of injectable drugs, over the past couple of years. The stock was not distressed and this is not a bargain basement acquisition. Justifying the acquisition premium with cost/revenue synergies and strategic objectives is tough to do. Essentially, Pfizer management believes the market has significantly undervalued Hospira.

After a long hiatus, M&A bounced back last year. Most of the purchase activity is coming from corporate buyers, rather than financial buyers (e.g., private equity firms, leverage buyout firms, etc.). Because corporate buyers know and live their industries, market observers consider them a better indicator of business health and valuation than financial buyers.

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Nicholas Atkeson and Andrew Houghton are the founding partners of Delta Investment Management, a registered investment advisory firm in San Francisco, and authors of the new book, Win by Not Losing: A Disciplined Approach To Building And Protecting Your Wealth In The Stock Market By Managing Your RiskAdditional market commentary and investment advice is available via their websites at www.deltaim.com and www.deltawealthaccelerator.com

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