The Rule Of 20 & Why The Bear Market Remains

The “Rule Of 20” says the “bear market” may just be resting despite much commentary to the contrary. In a recent article, Bank of America strategist Savita Subramanian warned clients that stocks are still expensive despite this year’s drawdown.

“Our analysis of the ERP indicates a 20% likelihood of a recession is now priced in vs. 36% in June. In March, stocks priced in a 75% probability of recession. Even on Enterprise Value to Sales, where sales should be elevated by the tailwind of 9% CPI, the market multiple is excessively elevated (+40%) relative to history – possibly because real sales growth ex-Energy is essentially flat.”

Such is a critically important point due to the massive influx of capital in recent years.

“There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. The current cycle isn’t unusual in its form, only its extent.”Howard Marks, Oaktree Capital Management

With the Federal Reserve reversing that monetary accommodation, such poses a very significant, and likely unrealized, risk to investors. Such brings us to the “Rule Of 20,” which suggests the stock market is substantially overvalued, as BofA noted.

“Outside of inflation falling to 0%, or the S&P 500 falling to 2500, an earnings surprise of 50% would be required to satisfy the Rule of 20, while consensus is forecasting an aggressive and we think unachievable 8% growth rate in 2023 already.” – BofA

Unfortunately, the last time the “Rule Of 20” was overvalued was in 2007. That was when Howard Marks wrote that passage above. In other words, while things always seem different, they are almost always the same.