Rule of 20 says market bottom much lower. Plus, Canadian energy stocks that big-time investors are buying

The investing rule of 20 states that when a new U.S. bull market starts, the trailing price to earnings (PE) ratio of the S&P 500 added to the inflation rate will result in a number less than 20. Unfortunately, right now the trailing PE ratio is 20.2 and the inflation rate is 8.5.

BofA Securities U.S. quantitative strategist Savita Subramanian reminded investors of the rule of 20 in a report last week. She described the rule as having a perfect track record in that the U.S. market has never hit a sustainable bottom when the PE ratio and consumer price index (CPI) combined for a plus-20 value.

The strategist also noted that the rule of 20 implies a new bull market in the short term won’t start unless inflation went to zero, the S&P 500 fell 40 per cent to 2500, or earnings are reported 50 per cent above expectations.

She does not believe an upside surprise in profits is in the cards, describing the consensus view of 8 per cent in year over year earnings growth in 2023 as not only aggressive – but unachievable.

The rule of 20 is not the only reason Ms. Subramanian is expecting more weakness in equities. The strategist maintains a 10-part list of ‘bull market signposts’ – economic and market data like unemployment, investor sentiment, Federal Reserve policy, and the yield curve – that often accompany new bull markets. Only 30 per cent of these signposts are now visible, compared with the usual 80 per cent when markets form sustainable bottoms.

Fully 17 of the 20 valuation measures BofA tracks indicate that the U.S. equity market is expensive relative to history. The cyclically adjusted PE or CAPE ratio (also known as the Shiller PE) is 67 per cent higher than the historical average, for example, and the enterprise value to sales ratio remains 40 per cent higher than average.

Monday’s S&P Global U.S. Services PMI report, expected to show a mild contraction in business activity at 49.8 (a reading of 50 indicates no change), actually came in a more deeply contractionary 44.1. This provided more evidence of a slowing U.S. economy.

So valuations are lofty at a time when economic growth is slowing. This is a recipe for cuts in profit expectations and investors should brace themselves for market volatility though the fall of 2022.

— Scott Barlow, Globe and Mail market strategist

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Stocks to ponder

Air Canada (AC-T) Listen to anyone who has tried to board a plane recently and you might conclude that flight cancellations and airport mayhem make this the worst-ever time to fly. Perhaps it is, but the stock market is suggesting the worst may be over. Air Canada’s share price has rebounded about 10 per cent from its recent low in July, soon after the airline announced the cancellation of dozens of daily flights in the summer, amid what the airline’s chief executive Michael Rousseau called “strains on all aspects of the global aviation system.” Turns out, buying the stock at a time when complaints about lost luggage and absurd lineups were leading nightly television newscasts in July was a profitable strategy. David Berman explains why.

The Rundown

Interested in following Warren Buffett into the energy sector? Here’s a start

Warren Buffett’s bet on Occidental Petroleum Corp. supports the long-term case for oil and gas stocks at a time when global demand for traditional energy sources is on the rise. His stake in the U.S. oil and gas producer also raises the question of how other sophisticated investors are approaching the sector amid concerns of slowing global economic activity. The answer: Their interest in it appears to be rising, and that includes several Canadian names. David Berman tells us more.

What TD’s chief economist foresees for housing prices, interest rates and inflation

To get a better sense of where the economy, inflation, interest rates and the housing market may be headed, The Globe and Mail’s Jennifer Dowty speaks with Toronto-Dominion Bank chief economist Beata Caranci.

BlackRock and RBC see growing demand for fixed-income ETFs as investors seek safe havens

As shaky markets steer investors toward safe-haven investments, Canada’s largest exchange-traded fund duo, BlackRock Inc. and Royal Bank of Canada, are seeing growing demand for fixed-income products, as well as sustainable funds with an ESG focus. Clare O’Hara reports.

Others (for subscribers)

National Bank updates its Dividend All-Stars portfolio

TSX seen higher in 2022, 2023 despite selloff fears: poll

Wednesday’s analyst upgrades and downgrades: Ratings lowered on Scotiabank

Tuesday’s analyst upgrades and downgrades

Globe Advisor

Why the recent flurry of tech firms’ stock splits is a positive for portfolio construction

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Ask Globe Investor

Question: I own American depositary shares of GSK PLC (GSK-N). According to my June 30 statement, I held 2,700 GSK shares with an adjusted cost base (ACB) of US$40.34 and a market value of US$43.53. However, my July 31 statement says I now own only 2,160 GSK shares with an ACB of US$50.42 and a market value of US$42.17, in addition to 2,700 new shares of Haleon PLC with an ACB of US$7.45 and market value of US$7.03. Now I have a loss on paper for my GSK shares. What’s going on here?

Answer: In July, British pharmaceutical company GSK PLC spun out its consumer health care business – maker of Advil, Sensodyne, Centrum, Tums and other brands – as a separate publicly traded company called Haleon PLC (HLN-N). Investors received one Haleon share for each GSK share held.

All else being equal, spinning out the value of Haleon would have caused GSK’s share price to drop substantially. To avoid that – and to make its share price and earnings per share roughly comparable with previous periods – GSK decided to consolidate its shares on a four-for-five basis, meaning the number of shares would decrease but each share would be worth more. That’s why you now own four-fifths as many GSK shares but the share price as of July 31 was similar to the price on June 30.

As for the ACB of your GSK shares, this is where things get more interesting. In a supplementary document, GSK stated that investors should allocate the aggregate cost of their original GSK depositary shares across their new GSK and Haleon shares in proportion to the relative market value of each. The company provided a sample calculation showing that, based on July 18 closing prices of GSK and Haleon on the London Stock Exchange, 81.84 per cent of the original ACB should be allocated to the GSK shares, with the remaining 18.16 per cent allocated to the Haleon shares.

However, I suspect your broker did not follow this method. If you multiply your original cost base of US$40.34 per share by 2,700 GSK shares, your total cost works out to US$108,918. But if you multiply the new ACB (provided by your broker) of US$50.42 by your current 2,160 GSK shares, you get a very similar number of US$108,907. I don’t see how that can be right, because a chunk of your total ACB should have been allocated to Haleon.

I suggest you read the GSK document and discuss any concerns with your broker or a tax professional. Finally, keep in mind that adjustments to the ACB don’t affect the value of an investment. They only affect the size of the capital gain or loss that will ultimately be reported for tax purposes. A higher ACB – even if it may not be correct in this case – is generally a good thing, because it means lower taxes down the road.

–John Heinzl

What’s up in the days ahead

David Berman looks ahead to what September may bring for markets.

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Compiled by Globe Investor Staff

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