It has been a difficult year for equities and the P/E ratio for the S&P 500 has dipped below its 20 yrs average. Does it mean that equities are attractively valued? Probably not if the “Rule of 20” is to be taken into account. Developed by Peter Lynch, one of the most successful and well-known investors of all time, the Rule of 20 maintains that markets may be “fairly” valued when the sum of the P/E ratio and the annual inflation rate equals 20.

Given the current level of inflation, the trailing PE “adjusted” for the Rule of 20 would be 28.3 hence significantly higher than Peter Lynch’s “fair” value. Granted that, as future earnings typically grow over time, the equity market tends to trade above such valuation, as inflation started to rise, the divergence vs the Rule of 20 started to widen (see chart). Using the forward PE value, currently at 16.4, the valuation adjusted for CPI returns a less extreme, but still elevated, 25 (=16.4+8.6). We would need to go back to the 1970s & 1980s to find readings where the spread between PE and the CPI-adjusted was so elevated.

The idea that PE ratios should be “discounted” by the level of inflation is consistent with data showing that valuations tend to compress during inflationary regimes, often trading far below “fair” value (see here: https://lnkd.in/dbbRfkUR). If we take the OECD 2022 US CPI forecast (5.7) a “fair” PE level would be 14.3, a 13% decline from Friday’s close and roughly 3,392 for the S&P 500. Should inflation persist at historically elevated levels, we may see the equities reaching far lower levels and possibly dip into single digits as we saw in the 19070s-80s. As most investors have never experienced high inflation regimes, the “recency bias” is rather powerful and may lead them to believe that a 16 PE provide an attractive entry level. They may want to reconsider. Disclosure: Hold all assets mentioned. Not investment advice. Do your own research.
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