We and most others spend much of our valuation efforts studiously applying somebody else’s valuation methods to make guesses about future prices.  In an act of personal liberation, we thought we’d try something different.  However, if this thinking is not original, then our “something different” is the same as something different on a Monty Python episode.

Let us preface this discussion with the fact that correlation is not the same thing as causation, and with the possibility that if enough effort is applied it may be possible to draw a correlation between stock market prices and variations in sun spots or women’s hemlines.  Nonetheless, we think that corporate bond rates and stock prices do have some natural and functionally tied relationship.

Consequently, you may find this thought provoking.

Stocks are riskier than bonds.  Therefore, for mature companies (not new or high growth rate companies), stocks have a higher earnings yield requirement than the yield on a corresponding bond from the same company.  It is probably fair to think of the S&P 500 index as being similar to a mature company.

What if the 10-year AAA, AA and A level S&P corporate bond rating levels could be correlated conceptually with Good Times, Normal Times and Bad Times (or Optimistic, Neutral and Pessimistic views)?

The aggregate 10-year corporate bond rates today are:

• AAA: 5.25%
• AA: 6.39%
• A: 11.24%

If we apply a 0%, 1%, 2% and 3% risk premium to required stock earnings yields, and make the Good Times (Optimistic), Normal Times (Neutral) and Bad Times (Pessimistic) conceptual leap for bond ratings, the implied P/E ratios for stocks would be (from low 0% to high 3% required risk premium):

• Optimistic View: 19.0, 16.0, 13.8, 12.1
• Neutral View: 15.6, 13.5, 11.9, 10.6
• Pessimistic View: 8.9, 8.2, 7.6, 7.0

Continuing this flight into the untested, and using a generalized $50 “normalized” earnings for the index (see prior article), the range of 2009 S&P 500 index values, depending on view from optimistic to pessimistic, might roughly be:

• Optimistic View: 600 to 950
• Neutral View: 550 to 800
• Pessimistic View: 350 to 450

If you put a 20% upside adjustment on the $50 normalized “as reported” earnings, you get $60 which approximates the street consensus on “operating earnings” (excludes the bad things that managements say are non-recurring in nature).  If we use that number for our “E”, the range of 2009 index values might be:

• Optimistic View: 720 to 1140
• Neutral View: 660 to 960
• Pessimistic View: 420 to 540

Strangely enough, whether intellectually valid or not, this general approach produces estimates of 2009 year-end value that are not inconsistent with other traditional earnings-based methods, as well as chart-based methods, of guessing about the future.

Think of this article a contribution to the ongoing dialog, but in no way a proclamation. We really don’t know how valid this method may be, but we do find it interesting.  Perhaps it will stimulate you to explore other related methods to try to put the current markets in a proper value perspective.

We don’t suggest relying on this method, but it may be worthy of notation.

Richard Shaw
QVM Group LLC

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