The Rule of 20 Is Fracturing: Why the S&P 500's Valuation Logic No Longer Fits 2026

The Rule of 20-a heuristic that suggests the sum of the S&P 500's price-to-earnings (P/E) ratio and the U.S. 10-year Treasury yield should approximate 20-has long served as a shorthand for market valuation. When the total is below 20, stocks are considered undervalued; above 20, overvalued. But in 2026, this formula is unraveling, not because of a breakdown in financial logic, but because of a fundamental shift in the forces driving asset prices.

As of November 26, 2025, the S&P 500's trailing P/E ratio stood at 30.81 according to one widely followed metric, while another placed it at 25.25. Meanwhile, the 10-year Treasury yield hovered at 4.00%. By the Rule of 20's old standards, this would imply a combined total of 34.81 or 29.25-far above the 20 benchmark, suggesting extreme overvaluation. Yet investors continue to pour money into equities, defying the logic. The disconnect is not a flaw in the data but a symptom of a broader transformation in the global economy.

The Rule of 20's Structural Weakness

The Rule of 20 assumes a stable relationship between bond yields and stock valuations, rooted in the idea that investors trade off between the safety of Treasuries and the growth potential of equities. But this relationship has been upended by three structural forces:

1. AI-Driven Earnings Growth: Fiscal stimulus and artificial intelligence (AI) investment are turbocharging corporate earnings. AI-related capital expenditures are projected to reach nearly $520 billion in 2026, creating a new era of productivity gains. This has led to forward-looking P/E ratios as of 2026 Q3 that reflect optimism about future cash flows, not just current earnings.

2. Prolonged Low-Interest-Rate Environments: The Federal Reserve's rate-cutting cycle, expected to continue into 2026, has pushed the 10-year yield below 4.00% and could see it fall further to 3.77% within a year. Lower bond yields reduce the opportunity cost of holding equities, allowing investors to justify higher P/E ratios even as yields decline.

3. Shifts in Investor Behavior: Institutional investors, flush with liquidity from quantitative easing and fiscal spending, are prioritizing growth over income. This has created a "Goldilocks" scenario where equities are valued not just for their earnings but for their role in portfolio diversification and inflation hedging-a dynamic the Rule of 20 does not account for.

Why the Rule of 20 Fails in 2026

The Rule of 20's simplicity is both its strength and its weakness. It assumes a linear relationship between bond yields and stock valuations, but the current environment is anything but linear. For example:
- Divergent Drivers: While the 10-year yield has fallen to 4.00%, the S&P 500's elevated P/E reflects expectations of AI-driven earnings growth, not just interest rate comparisons. This decouples the two metrics in a way the Rule of 20 cannot explain.
- Forward-Looking Valuations: The forward P/E of 22.5X is higher than the five-year average of 19.9X as of Q3 2025, but it is justified by forecasts of sustained earnings growth. The Rule of 20, which relies on trailing P/E, misses this forward momentum.

- Global Capital Flows: U.S. Treasuries remain a global safe haven, but capital is also flowing into equities due to a lack of alternatives. This dual demand is not captured by the Rule of 20's binary framework.

Implications for Investors

The erosion of the Rule of 20's predictive power does not mean investors should abandon valuation metrics. Instead, it calls for a more nuanced approach:
- Focus on Earnings Quality: With AI and fiscal stimulus driving growth, investors must scrutinize the sustainability of corporate earnings. Are companies investing in long-term productivity, or are they propping up short-term numbers?
- Rebalance Risk Assumptions: Lower bond yields mean equities must deliver higher returns to justify their valuations. Investors should assess whether companies can meet these expectations.
- Monitor Policy Shifts: The Federal Reserve's actions and fiscal policy decisions will continue to shape both bond yields and equity valuations. A sudden pivot in monetary policy could reintroduce volatility.

The Rule of 20 was a useful tool in a world where interest rates and earnings moved in tandem. But in 2026, the world has changed. Investors must now navigate a landscape where AI, fiscal stimulus, and shifting capital flows redefine the rules of the game. The Rule of 20 is not dead-it is simply outdated.