With Corporate Profits Up, Why Is the Market So Glum?

With second-quarter earnings season winding down, companies in the S&P 500 have so far reported an increase in earnings per share of about 29%. And companies have plenty of cash -- $1.84 trillion to be specific, according the Federal Reserve. But yesterday the stock market lost almost 3%. Why so glum, market?

The first thing to point out is that there is no way to fully explain why stocks go up or down every day. Yet the media feel compelled to come up story lines that serve as an explanation. The latest one is the "Fed is out of bullets" -- the idea that investors have lost confidence in the U.S. central bank because there's nothing more it can do to fix the economy. If that were a valid explanation, then how would it explain why stocks rose Tuesday as a foreshadowing of the Fed's latest pronouncement was being broadcast?

Some also savor the opportunity to jump on every piece of news -- related or not -- as a way to confirm their political beliefs. On Wednesday, a colleague sent me an email about the state of the U.S. economy, along with a link about the jobless statistics citing them as evidence to support why the stock market fell. Along with the link, came his note: "I believe that recovery summer has gone bye bye. Looks like today's stock market thinks this way. Look at the comments for some flavor about what people are thinking,"

The News Doesn't Move High-Frequency Traders

So what exactly moves the market each day? As I've written in DailyFinance, 70% of daily trading volume is conducted by so-called high-frequency traders. These HFTs buy trading data so they know a fraction of a second before an order is executed that, say, a huge sell order for a particular stock is coming up. HFTs use such information to bet on that stock's decline right before the trade is executed.

In holding their positions for an average of 11 seconds to make a few pennies of profit, HFTs have little time to contemplate a company's earnings or what might be going on in the economy.

Over the long run, stock prices should reflect future earnings. Currently carrying a price-earnings ratio of 12, stocks are historically cheap -- trading far below the long-term average P/E of 15.5. By another measure, the so-called price/earnings to growth (PEG) ratio, stocks are a screaming buy. Eight thousand analysts surveyed by Bloomberg think the S&P 500 companies will post a 35% rise in 2010 earnings. Based on that, stocks are trading at a PEG of 0.34. I think a PEG of 1 is reasonably valued.

A recent NBC/Wall Street Journal poll suggests that Americans are feeling quite surly toward Washington and gloomy about the economy. In my view, the hot summer weather is just as good an explanation of why stocks fell as the results of this poll.

Just because two events happen on the same day, it doesn't mean that one caused the other. So cheer up, market! Earnings are growing, cash is high, P/Es are low and nobody wants to go anywhere near stocks. Hold your nose and buy.