The recent stock market rout has left equities no longer trading at the expensive valuations that I had been concerned about. They aren’t cheap either, so I don’t plan to do any buying at current levels. But I have closed virtually all of my short positions leaving my portfolio with lots of cash. My reasoning for believing that stocks have become more fairly priced is based on my outlook for earnings and the multiple the market will assign to those earnings.

S&P 500 four-quarter rolling operating earnings peaked at $90 during the 2nd quarter of last year. After the second quarter of this year earnings have declined to $70. Given that the only driver of earnings growth, energy and materials companies, will now suffer declining earnings, I expect at some point over the next year S&P 500 earnings will bottom within the $50-$60 range and will remain there for several more quarters.

Typically PE ratios are in the single digits during both deflationary periods because of worries of plummeting earnings and highly inflationary periods when investors demand a greater earnings yield to compensate for a rising cost of living. While inflation has been uncomfortably high recently, I believe we are entering a disinflationary period where the market will assign a multiple close to the historical average which is 15.

So if we get earnings of $50-$60 and multiply it by 15, I get a fair value for the S&P 500 of around 750 to 900. I felt very comfortable taking a big short position when the S&P 500 was trading at over 1300 earlier this year. But last week it dipped below 900 and I had no reason to remain short. If the market rallies to around 1100 I will re-establish a big short position. If the market continues to drop and falls to below 600, I will probably go aggressively long. But within 600 and 1100 I’m not going to make any big bets.

Currently, I’m almost entirely in cash. I own Altius Minerals (TSX:ALS), a handful of tiny positions in micro-cap resource stocks, a short position in MBIA (NYSE: MBI) calls, and a short position in 30 year Treasury bonds. Because I don’t see any significant mispricings in the equities, commodities, credit, and currency markets, I’m going to wait patiently for opportunities to present themselves which they always do with high frequency.