The title is the new equation of finance in stock and bond markets.  We will summarize in less than a thousand words.

We have revised our earnings estimates for the S&P 500.  There was a time a year ago when the outlook suggested this number could reach $100.  We based that assumption on the outlook that world economic growth would exceed 5% and be driven by the Asian Emerging miracle.  We thought that other global forces would follow.  Well, so much for the optimistic view.

Subprime mess and financial turmoil and write-offs and slowdown have dealt that estimate a fatal blow.  $100 for the S&P is a long way off.   World growth is now estimated at slightly under 4% for 2008.  Asian and Emerging economies will still lead but not as robustly as thought.   The US slump is well known.  The European and Japanese slowdowns are persisting.  We do not see a worldwide recession or depression. 

This is slowdown, not a stop.

Dysfunctional credit markets are clearing slowly.  The LIBOR rate spread to other key US rates has returned to normalcy.  LIBOR is down 2 full percentage points in 8 weeks.  The Fed’s Term Auction Facility (TAF) has worked.  The LIBOR banks didn’t trust each other and the rest of the world didn’t trust them.  So LIBOR premiums blew out of historical ranges. 

The TAF allowed the Fed to loan cash directly to US member banks.  TAF bypassed LIBOR.  That bypass worked like a stent in a blocked artery.  Once the liquidity blood started to flow, short term market based rates plummeted. 

Not all credit markets have returned to normal.  The Muni market is in disarray.  See my colleague John Mousseau’s research comment published earlier this week, www.cumber.com .  There are terrific opportunities in this $2 ½ trillion dollar US specific Muni sector.

So what about stocks?

We expect that operating earnings for 2007, 2008 and 2009 will be flat and average around $90.  That is a lot lower than Wall Street expectations a year ago.   The downward movement of stock prices has adjusted to this expectation.   We believe that stocks now represent a value provided your forecast is not for a prolonged and serious recession.  If you believe that a major economic slowdown is still ahead, you should avoid the US stock market. 

We don’t believe that.  We think that the period ahead is one of slow growth and a boring time for investors.  Fast money on spiking stock prices or the acute fear response from plummeting forced liquidation is likely to subside.  Folks won’t like that.  They won’t get the emotional head rush that comes with volatility.   Boring markets are not in most people’s expectations.

Let’s assume our forecast of three years of $90 dollar S&P 500 earnings is close to the mark.   At 17 times those earnings, the S&P 500 index would be 1530.  The earnings yield is about 6%.  You calculate this by dividing the P/E into 100.  Compare that earnings yield with the riskless yield on the 10-year US Treasury note.  T-note yields are about 3.5% for this exercise.  Subtract the T-note yield from the earnings yield and you have an estimate of the equity risk premium.  That is currently about 2 1/2%. 

And equity risk premium on the 500 large stocks in the S&P 500 index is very high.  It presents a rare bargain.  It says that by owning the stocks instead of the riskless T-note you are gaining an additional 2 ½% return per year on your investment.  That is the result from applying funds to about two-thirds of the entire stock market capitalization of the United States.  Long term strategic investors do not get this opportunity often.  A 2 ½ point equity risk premium in the US is a bargain by historical standards.

That is why Cumberland is scaling into a fully invested position.  We still have to choose the sectors and the weights.   And we are presently holding some cash reserve because we expect the market to be rocky in the short term.  We think it is likely to retest the lows seen in early January.  We intend to commit funds into any selloff.  In fact, we are committing some funds into the market at these levels and did so in the last week. 

At Cumberland, we only use exchange traded funds (ETF) for our equity strategies.  We will discuss the sectors and choices after accounts have been rebalanced and fully repositioned.  For now readers will need to be patient and understand that our managed client’s accounts come first. 

We reiterate our very strong recommendation in favor of the tax-free Muni market.  The offerings in this market require homework.  You must not rely on credit rating agencies nor can you do so on the bond insurers. 

At Cumberland, we have an independent division that has advised Muni issuers for decades.  We have consulted on billions of new bond issues over the years.  We comment on bond indentures and understand how to value the options in a Muni.   The details on that are quite technical and beyond this short commentary. 

But our conclusion is clear.   The tax-free municipal bond market in the US now offers one of the rare and compelling financial market values that do not come around often.   Our Cumberland accounts are fully positioned in their Muni allocation using a barbell strategy.   For details on this see John Mousseau’s excellent work:  http://www.cumber.com/commentary.aspx?file=020508.asp&n=l_mc .