Stock Price Evaluation-A Starter.

I prefer to deal in probabilities since nobody can predict the future. With that in mind I've given some thought to the markets valuation. The market has had to deal with two huge issues.

The first has been the massive world wide deleveraging and contraction that has been occurring. I believe the majority of this has been priced into stocks. I do believe that markets have mostly discounted the further systemic risk of significant failure by a major financial institution. While the odds against this cannot ever be 0. I would assign a probability of another major institution going belly up at less than 10%.

The second issue is how deep of a recession are stocks currently discounting? Obviously nobody has an answer to that as yet. For our own economic analysis right now we are using this scenario: The US has been in a recession since the beginning of 2007. Economic decline began in earnest at the end of September and we will see at least three-four quarters of negative economic growth. We see trough economic numbers being reported in the first quarter of 2009. The second quarter will be negative but better and marginal growth will return sometime in 2009's third quarter. We are using a ball park range on S&P 500 earnings between $62 & $75 for 2009. We are using a very broad and preliminary scale of $73-$86 for 2010. Obviously we will change this scenario as time passes but this is where we stand today.

Also when evaluating equities one has to look at investment alternatives. Longer term government bonds are yielding between 3.6%-3.9%. Since this is considered a risk free rate of return one ought to demand a higher rate of return from stocks as compensation for the simple fact that they are more volatile and a riskier asset class than bonds. The Consigliere always said demand a 5% return greater than the 10 year bond before even looking at an investment. In this environment I'm upping that number to 6%. So at a minimum I basically need a 10% return over the next 12-18 months to be interested in buying.

With that in mind and using the range of our earnings analysis:

The PE {Price to Earnings Ratio} on stocks is currently between 15 & 12.5 based on our projected 2009 earnings range. Stocks are either currently then fairly valued at around 15 times next years numbers or are historically cheaper than they usually trade. Based on these numbers we can infer current equity valuation on the S&P 500 of 930-1,125. That is all things equal probability indicates that the S&P 500 stocks should be worth in aggregate this amount by the end of 2009. This equates to a possible current total return of -2% to 21% by year end 2009.

Assuming our 2010 numbers are somewhere within the ball park then stocks trade between 12.9 & 11 times 2010 numbers. This analysis says that stocks are currently historically cheaper than where they usually trade. Based on these numbers we can infer current equity valuation on the S&P 500 of 1,022-1,450. That is all things equal, probability indicates that the S&P 500 stocks should be worth in aggregate this amount by the end of 2009. This equates to a possible current total return of 12%-58% by year end 2010.

Again these are just the probabilities we are working with. Nothing says these will come about. They are unlikely to come about if the recession is worse than it currently looks. They could also be better if the recession is not as deep as most of us fear. But this is our base line starting point of analysis as we go forward managing client's money.