8. Valuations.

As I outlined in Your S&P Road Map in March of 2009, valuations reached levels that reflected irrational despondence. Amateurish articles were being published in the financial press proclaiming that based on current earnings, fair value for the S&P 500 was 600, 500, 400, or even 300. These articles seemed blithely ignorant of the concept of normalized earnings or of the idea that current equity values must discount the net present value of all cash flows into the indefinite future -- not the cash flows of any particular year or years. History has shown that when valuations reach such extreme lows, the probabilities of upside appreciation are quite favorable.

The countertrend rally since March has brought valuations within parameters that are still low, but which are at least near levels that can be considered normal. It can be empirically shown that with valuations at current levels, odds for current upside or downside are close to even. As such, valuation no longer provides a support for the market.

Psychological Factors

9. Psychology.

Fundamentals are important. However, just as critical are 2 factors. First: Which fundamentals will market participants focus on? There's an overwhelming amount of data available, much of it contradictory. Which data market participants choose to focus on depends on their biases and their state of mind. Second: How will they interpret the data? The same data can be interpreted by reasonable people in different ways.

The psychology that pervaded marginal market participants from late 2008 through early 2009 was one of “irrational despondence.” The doom and gloom got completely ridiculous. Pundits were proclaiming the collapse of the US dollar, the end of the American dream, deflation, hyperinflation, and much more sensationalist and even contradictory nonsense.

The nonsense got so out of hand, in fact, that people were calling for the nationalization of the US banking system -- a position driven by hysteria and an utter lack of understanding of the fundamentals of the US financial system (see Are US Banks Worthless?). At this time, the marginal market participant was seeing only the downside and completely ignoring potential upside. It was pretty clear that as soon as people realized that things were not as hopeless as they'd been led to believe -- and that there were viable short-, medium- and long-term solutions to the various problems afflicting the nation -- the market would rally strongly. The problem is that after 3 months of psychological relief, better-than-expected news seems to have become old hat (see A Sign of Market Exhaustion?).

And the old bearish bugaboo tales of deficits, debt, money growth, etc. seem to be coming back in style. The mood has shifted from one of surprise (that things weren't as bad as expected), to one in which people are focusing once again on the fact that it's “still bad.” In this context, folks are looking for reasons why things are bad -- and this causes them to gravitate towards bearish explanations and ways of looking at the world.

Put it together: Worse-than-expected news and a prevalent psychology that seems to be looking for bad news. It's a recipe for lower asset prices.

Technical Factors

10. Exhaustion.

In a series of Buzz & Banter posts from mid-June, I laid out a technical framework for analyzing markets during the weeks prior to earnings season. It's been and remains my position that second-quarter earnings will, on balance, provide positive surprises. However, I've been clear in stating that the level at which the market entered earnings season would be critical. It was my position that if the market could enter into the earnings season above the 920-930 level, that it would catapult past the 950 resistance level and pick up a second wind past 965.