The recent schizophrenia of the stock market results from conflicting bearish and bullish influences. The bearish sentiment is caused by the pervasive but understandable pessimism stemming from the inability of Western governments to get their financial houses in order. The bullish trends in the core fundamentals get far less attention.

Quick Pop Quiz

To illustrate the degree to which core stock market fundamentals have been swamped in the media by issues related to government deficits, try answering the questions in this short quiz.

What is the percentage change in the S&P index? 
    1) From one year ago. 
    2) From two years ago. 
    3) From three years ago.

What is the percentage change in 2011 aggregate S&P 500 operating earnings? 
    4) From one year ago 
    5) From two years ago.

What has real GDP growth been? 
    6) Over the past year. 
    7) Over the past two years.

The unemployment rate is currently 9.0%. What was it? 
    8) One year ago. 
    9) Two years ago.

The Answers

The S&P 500 index is up 1.6% from a year ago, 9.5% from two years ago, and 41.5% from three years ago. (Based on the Friday close of 1215.65)

S&P 500 earnings for 2011 (including an estimate for the fourth quarter) will be up 14.8% from 2010, and up 58.3% from 2009 (including 37.8% growth from 2009 to 2010).

The US economy in the third quarter of 2011 grew 1.6% from the third quarter of 2010, and is up 5.2% from the third quarter of 2009 (including 3.5% growth from the third quarter of 2009 to the third quarter of 2010).

The unemployment rate in October 2011 was 9.0%, down from 9.7% in October 2010 and 10.1% in October 2009.

In Perspective

These are strange numbers for what is still widely described as a bear market amidst recessionary conditions.

The stock market is up, earnings are surging, the economy is growing at a solid pace, and the unemployment rate is declining.

Yet, it is easy to find articles that explain “how investors should adapt to the bear market” or “how to handle risk in recessionary times.” Just turn on the TV and assess the prevailing attitude – overwhelming pessimism.

Now, before readers point out all that is wrong with the world, we’ll drop in the necessary disclaimers.

First, there are clearly risks to equity markets from potential credit market turmoil caused by the inability of Western governments to get their financial houses in order.

Second, economic conditions remain lousy. Unemployment is high and there is tremendous economic anxiety in the US.

Third, the stock market remains well off its peak and retirement funds for many are still substantially below previous levels.

Fourth, the housing market remains deeply depressed and will probably remain so for years.

All this means that total wealth for many is below previous levels, and it may take years to recover lost ground.

Nevertheless, it would be a mistake to ignore the underlying trends in the core fundamentals. These trends have produced solid returns on investments in high quality, multinational, dividend-paying stocks in recent years.

The goal for investors should be to maximize returns in the years ahead, based on individual risk-reward parameters, and to balance the conflicting bullish and bearish considerations without getting wrapped up in the emotionalism of the latest headline.

Earnings as an Example of Underreported Positive News

Third quarter earnings for the S&P 500 in aggregate were up 16% from the same quarter in 2010. That was not only well above expectations, it is very impressive in its own right. Hardly anyone noticed.

The stock market bounced off the summer lows, but the focus has remained squarely on European debt problems and now has moved to the US budget problems.

Earnings for the past four quarters are now approximately $95.50. That means that the earnings yield (earnings/price) on the S&P 500 is an outstanding 7.9%. In terms of the inverse, the more traditional valuation metric of the P/E (price/earnings) stands at just 12.7.

This represents tremendous value compared to the meager 1.96% yield on the 10-year government note.

Furthermore, earnings for the coming four quarters (Q4 2011 to Q3 2012) are expected to rise 5% to 10%, according to the most widely used Wall Street services.

There is no way to view the recent and prospective earnings data as anything other than bullish.

Economic Conditions

The economic data have been significantly more upbeat in recent weeks, and are likely to continue to be so in the months ahead.

Third quarter real GDP was up at a 2.5% annual rate. The data for the fourth quarter are lining up towards a 3% or higher rate of increase.

The second half of this year is thus likely to post growth near 3%, compared to the sub-1% growth in the first half of the year. And, growth in 2012 should stay near 3% based on rising employment and investment (so long as government missteps don’t undermine business trends).

And, as noted above, the unemployment rate is actually trending down.

The reality is that economic conditions are improving, albeit from poor conditions. But it is the change in economic conditions that is important to the future prospects for stock prices, not the level.

The improvement in economic trends has had little impact on overall sentiment, except perhaps to slightly reduce the number of prognostications of an imminent double-dip recession.

What it All Means

Risks remain high for stock investors. Volatility will persist. There is little doubt that negativism will continue to dominate the media.

Yet, astute investors shouldn’t let the overwhelming pessimism obscure the facts that core fundamentals have been bullish the past couple of years and are likely to continue to improve.

The contrasting realities of bullish fundamentals and the bearish concerns about government budget imbalances are both important – even if one gets far more air time than the other.

Investments in high quality, dividend-paying stocks have paid off for risk-averse investors over the past few years. They are likely to provide good returns in the years ahead as well. After all, higher earnings lead to higher dividends - and those dividend checks can make a huge difference in this low interest rate environment.

--Dick Green, Briefing.com