What Is the Rule Of 18?

Rule of 18 is an informal rule of thumb that can supposedly reveal whether the next move for the stock market is up or down. It can be computed by adding the inflation rate to the price-to-earnings ratio (P/E) of the Dow Jones Industrial Average (DJIA). If the total is above 18, stocks are supposed to decrease. If the total is under 18, stocks are expected to increase.

Key Takeaways

  • The Rule of 18 is a heuristic indicator that is supposed to predict short-term movements of the stock market.
  • The rule works by simply adding the inflation rate to the P/E of the Dow Jones Industrial Average.
  • A value under 18 suggests a bull market, while a value over 18 a bear market. A similar "Rule of 20" uses twenty as its threshold instead.

Understanding the Rule Of 18

Rule of 18 is the name for a theory that can supposedly predict the direction of the stock market by adding together the annual rate of inflation and the P/E ratio of the Dow Jones Industrial Average. Although it may sound somewhat difficult to calculate, the equation is actually simple if you know where to look.

First, you want to find the P/E ratio of the Dow, a bellwether index of 30 blue-chips stocks designed to represent the performance of the overall domestic stock market. The P/E ratio of an index measures its total price divided by its total earnings. For use in the Rule of 18 calculation, some investors like to use the approximation provided by the P/E ratio of an exchange-traded fund (ETF) that closely tracks the index in question. For the Dow, investors can consult the SPDR Dow Jones Industrial Average ETF (DIA).

Once you know the P/E of the Dow, you add that number to the annual rate of inflation, which is determined by the Consumer Price Index and released by the U.S. Bureau of Labor Statistics. If the sum of the Dow’s P/E and the rate of inflation is below 18, then stock prices should increase. If the total is above 18, the next move for stock prices is expected to be downward.

Example

Let’s look at a hypothetical example. If the P/E for the Dow was 15 and the annual rate of inflation was 2 percent, their sum would equal 17. According to the Rule of 18, this number would indicate that the stock market will increase.

The Rule of 20

Somewhat similar to the Rule of 18 is the Rule of 20, a calculation that attempts to quickly determine if the equity market is fairly valued. The Rule of 20 suggests that stocks are fairly priced when the sum of the stock market’s P/E and the rate of inflation are equal to 20. Anything above 20 means that stocks appear to be getting expensive, while anything below 20 suggests that stocks are attractively priced.

While neither the Rule of 18 nor the Rule of 20 should be accepted as scientifically incontrovertible, both can provide investors with a quick and easy rule of thumb that may help inform their investment decisions.