Farrell: Why Risk/Reward Favors Investors

Go figure! Up one day and down the next, and all eyes are on Washington. Do they approve a rescue package or not? Who knows? What we need to do is get into the balcony and look down, while trying to put the emotions of the moment aside.

Yesterday was a truly awful day, with 98 percent of the volume on the downside. That usually is at least a short-term blow-off, and a knee-jerk reaction rally is common.

My colleague here at Soleil, Paul Leming of Soleil/Princeton Tech Research, loves history and dove back into the books: Since 1950, there have been 11 other days before yesterday that saw the S&P average decline 5 percent. In nine of the 11 instances, the market was higher 6 months later. Including the two times that saw a decline (of -2 percent and -8 percent, respectively), the median advance was 11 percent.

I have given up trying to call bottoms in the market. Becky Quick on Squawk Box said bottoms are better to watch than to try and catch, but the data is interesting.

Doug Kass, Lola Jane's honorary uncle, noted that the Chicago Board Volatility Index exceeded 50 for the seventh time in the past two decades, and the prior six breeches were soon followed by a rally of 15 percent.

The technical is interesting, so let's look at the fundamentals and what valuations could/should be. The peak in earnings for the S&P 500 index was reached in the second quarter of 2007, when they annualized at a $91.50 rate. The worst (so far) was Q2 of this year, when earnings annualized at $69 (financial company write-offs accounted for the slaughter).

During very stressful economic times, earnings on a normalized basis decline 15-17 percent in the extreme. Let's use a 17 percent decline off $91.50 to get to $76. I should note one of the best in the business, Jason Trennert of Strategas, is using $78 in earnings for 2009, and he is the lowest I am aware of. Average the two and we get $77 as an earnings estimate for 2009. The consensus is still way above that, so I feel good being at that number.

If earnings were to struggle to a $77 number, it is fair to guess that Treasury rates would be on the low side, so a multiple of 13 is conservative. 13 times $77 equals 1001 as a downside risk target for the S&P. The average closed yesterday at about 1100. A 100 point decline, or 10 percent, is our risk using this approach. I feel this is extreme, but so be it. If we saw an additional 10 percent to the downside, it would be a total of 40 percent off the October top.

The "average" bear market sees a decline of 31 percent. But when markets recover, the average gain following a bear market is usually over 30 percent. The risk/reward ratio is skewed in investors' favor.