over 1 year ago • 1 min
Analysts at Bank of America created a simple indicator that so far has a perfect record in predicting stock market bottoms. The Rule of 20 takes the S&P 500’s trailing price-to-earnings (P/E) ratio and adds it to the yearly inflation rate as measured by the US consumer price index (CPI). If the sum (black line) falls below 20 (red line), the bottom is in, the indicator says. And this has held true for every market trough since the 1950s (blue dots).
But the measure has only dipped as low as 27 this year, despite the sharp market selloff. In other words, this indicator is saying the market hasn’t bottomed yet, and the recent bounce is likely just a bear-market rally.
With the S&P 500’s P/E around 20 and the most recent US inflation reading at 8.5, the measure currently sits at 28.5. To get to 20, either the annual inflation rate would have to go to zero (very unlikely) or the S&P 500’s P/E ratio would have to dip by 8.5 points. The latter could happen if corporate earnings announcements deliver massively better-than-expected surprises (also very unlikely) or if the S&P 500’s price drops by 40% (the most realistic possibility).
Mind you, this assumes that the indicator will continue its flawless record. And, as you know, just because something’s always worked in the past doesn’t necessarily mean it always will in the future. But if you trust the Rule of 20, then you know we haven’t seen the market bottom yet and it’s not worth chasing the current rally.
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