'First, while Baa corporate spreads have narrowed sharply from their Armageddon highs, at 370 basis points they are still pricing in a very bad economic and financial market scenario - still wider than at any point of the 2001 or 1990 recessions or the 1998 LTCM/Russian debt default freeze-up. In fact, history suggests that the corporate default rate would have to rise well above 7% for corporate bonds to deliver negative returns with yields as high as they are at around 7¼%. In a 1¼% inflation rate world, this is a hefty 8½% real rate for investors to chew on. Not too shabby.

'The comparable yield in the equity market, depending on whether one uses reported or operating P/E multiples on forward or trailing earnings, is little better than 6½%. So corporate debt still trumps stocks. And what this 200 basis point ‘yield gap’ is telling you is that either corporate bond prices will need to rally more down the road or we need to start seeing corporate earnings growth recover sharply enough to pull those multiples down to more attractive levels.

'We went back in time to see what the typical one-year total returns for the S&P 500 when the starting point for the P/E multiple is in a 10x-20x range and we get any sort of positive earnings growth in the ensuing twelve months, and indeed that total return growth averages out to be nearly +15%. This is why the valuation is important - when the starting point on the multiple is closer to 30x, you need to see at least 20% earnings growth in the coming year to generate any positive returns in equities at all.

'Our analysis would seem to suggest, given the multiple that coincided with the market trough, and under the proviso that we at least see some moderate positive growth in corporate profits, that the March lows will hold. Our challenge now is navigating the forecast after a massive 40%+ rally that has already occurred without any evidence of a meaningful earnings turnaround. The onus was on the bears back in March; the onus is now on the bulls.

'Our point is that the equity market has already gone beyond - by a factor of three! - what is normal in terms of the returns it usually generates in a given year when the starting point on the multiple is low to mid teens and earnings are up, say, roughly 10%. In other words, there is a whole lot of good news priced into stocks at current price levels.

'From our vantage point, a pullback towards 800 on the S&P 500 would not only be justified under the prospective earnings landscape, but would likely also provide a welcome buying opportunity.”