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Two sides to every market

One of the least appreciated keys to becoming a successful investor is resigning yourself to operating under uncertain circumstances.

This may seem an odd statement. Some new investors assume that during bull markets the investing landscape looks good so investors buy stocks, whereas during bear markets the bad news is obvious so investors sell stocks. If only it were so simple.

The reality is there are always two sides to every market. Markets are made up of buyers and sellers interacting — every trade requires a buyer and seller. Naturally there are all types of buyers and sellers (people buying and selling for various reasons), but at essence, most of the trades that will be made today — and every other day — will be made between one party that believes the current price is a good one to sell at and another party that believes the exact same price represents a good buying opportunity.

This is the main reason why Sound Mind Investing spends so little effort trying to forecast what the market will do next. There are always two (or more!) compelling arguments regarding the most likely future path for the market. Equally brilliant experts line up on either side of the debate, half arguing the market will go up for one set of reasons, the other half arguing it will decline for a different set of reasons.

I bring this up today because it occurs to me that the negative (seller's) side of the market equation seems to be getting most of the headlines lately, and I suspect many investors aren't even aware of the primary positive (buyer's) argument.

The negatives at present are numerous and well known:

1. Massive financial problems in Europe threaten to unleash another act in the unfolding world credit drama;
2. The U.S. can't seem to come to any sort of solution regarding its own debt problem — with the seemingly important deadline of Aug. 2 for raising the national debt ceiling looming;
3. The Federal Reserve's "QE2" program officially ended on June 30, leaving significant questions as to what happens to our economy without this significant stimulus (not to mention if there will be adequate demand for our Treasury debt without the Fed as a buyer, and the impact that may have on interest rates);
4. The economy seems to be weakening, as was vividly demonstrated in last week's dismal jobs report.

What is the counterbalance to all this bad news? Or put differently, in light of all these negatives, what positive has been responsible for limiting losses in stocks this year to the roughly 7% decline in May-June?

The answer: Company profits have been strong. And not just a little strong. Really strong.

Starting in 2007, S&P 500 profits fell for nine consecutive quarters, with annual profits bottoming out at $60.59 per share in 2008. According to the article, earnings are forecast to reach $99.34 this year — a remarkable turnaround, even if the estimate does prove to be a bit high.

As a result of this tremendous earnings growth, the closely-watched P/E (price/earnings) ratio for the S&P 500 is actually still bouncing around the same level it was when the market was bottoming out in March 2009. That is quite unusual — P/E ratios typically expand during market-doubling bull markets. This leads many bulls to believe there is still plenty of room for stock prices to move higher.

Whether or not that's true is a discussion for another day. Just keep in mind that in the long-term, stock prices are tied to corporate earnings. So it makes sense that prices would rise as these earnings have rebounded.

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