As talk about the possibility of a recession swirls, investors are also keenly interested in when the markets will bottom out. Now one well-known analyst says one indicator that’s never been wrong, called the Rule of 20, is suggesting that the stock market has further to fall.
Market Pricing In A Lower Expectation Of Recession
In a recent note, Bank of American analyst Savita Subramanian said the market is now pricing in a 20% likelihood of a recession, although in March, a 75% probability was priced in. She added that the enterprise-value-to-sales multiple is also “excessively elevated relative to history,” up more than 40%.
Subramanian explained that the consumer price index’s increase of 9% should create a tailwind for sales, but the EV/ sales multiple could be high because real sales growth excluding energy is “essentially flat.” As a result, she believes stocks aren’t cheap enough yet because the market is underestimating the odds of an economic contraction.
As far as the market reaching a bottom, Subramanian said just 30% of the conditions needed to signal the market’s bottom have been triggered after the most recent rally that carried the S&P 500 up 17% from its low in mid-June. Generally, the market doesn’t bottom until at least 80% of those conditions have registered.
The Rule Of 20
More specifically, Subramanian called attention to the Rule of 20. The rule is triggered when the total of yearly consumer price inflation plus the market’s trailing price-to-earnings ratio is less than 20% and the market hits its trough. Currently, the market sits at a P/E of 20, while the CPI is at 8.5%, which amounts to 28.5.
Subramanian added that unless inflation declines to 0% or the S&P 500 plunge to 2,500, an earnings surprise of 50% would be needed to meet the Rule of 20. Consensus is calling for a growth rate of 8% next year, but she thinks that’s too aggressively and will ultimately prove to be unachievable.
Other signals would also have to be triggered to confirm the bottom of the market. According to Subramanian, those that haven’t yet been triggered include the Federal Reserve slashing interest rates, a decline of at least 50 basis points in the two-year Treasury yield, rising unemployment rather than the current 12-month low, and a buy signal from the sell-side indicator.
Potentially Investable Sectors
Based on all this information, she recommends industrial and energy stocks and advises investors to unload consumer-oriented stocks. For example, Subramanian believes the already-strong capital expenditures among industrial companies could give them a lift.
Capex had already grown 19% year over year in the second quarter. Industrial firms are also guiding for even more capital expenditures the rest of the year. Subramanian believes capital expenditures could be “more of a necessity amid a tight labor market” that could mean companies choose to automate their operations and deglobalize.
This article originally appeared on ValueWalk
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