This blog post originally appeared on RealMoney Silver on May 27 at 7:06 a.m. EDT.Away from the numerous fundamental headwinds -- higher tax rates, the long tail and aftershock of the last credit crisis (both here and abroad), deleveraging's role in slowing economic growth, risks of a double dip, geopolitical concerns, partisan politics and global fiscal imbalances -- individual and institutional investors' confidence is being shaken by the market's volatility and the sharp and random moves. As I have written, the market is in the hands of high-frequency trading strategies. Once accounting for 50% of the day's trading volume, that share has increased ever further (probably close to 70% now) in the face of hedge fund "de-risking" and in the absence of inflows into domestic equity mutual funds. Quick and sudden moves, such as we saw in the last half hour in trading last Friday and yesterday, are the consequences of the aforementioned low-volume voids filled by the HFT community's momentum-seeking weapons of market destruction. While I have argued in favor of killing the quants before they kill us, there is a brighter side of the negative impact of these dark pools of algorithmic trading strategies that are undermining market confidence.
- Investors replace renters: Renters are being taken out of the market as stocks move into stronger hands.
- Fear is the friend of the rational buyer: The introduction of fear (ever-present today) -- fear that an investor can lose 1%-3% in a nanosecond -- is an important ingredient to establishing a better foundation for a real rally in equities. Just look at the impact of fear on The Divine Ms. M's oversold oscillator this morning. In its usual place at the bottom of the page, it is all but ignored!
- Emotional markets create opportunity: When investors' fundamental views (which should account for almost all of our investment decisions) are thrust aside and are increasingly disregarded, hyperbole and emotion take over.
- Stronger U.S. economic prospects are ahead: As the HFT strategies wreck havoc, investors are increasingly losing sight of the relatively upbeat economic/fundamental recovery in the domestic economy.
- Rising equity risk premium provides good entry point: The markets are now discounting a second-half domestic slowdown and, by my calculation, are now discounting 2010 S&P earnings of only $70-$72 a share. The equity risk premium is now between 5%-6% -- well over the long-term trend line of 3.5%.
- S&P profits intact, P/E has contracted: The leading and coincident indicators still point to 2010 S&P earnings of $83-$85 a share. The market's multiple now stands at only 12.7 times, against 17 times when inflation and interest rates are contained (as they are now).