The Rise of the Machines (MSFT, NOG)

Now, since I mentioned fundamentals, that’s the place to begin our discussion of what’s happened to the stock market lately – and what we should be doing about it.

As I wrote yesterday, analysts and strategists alike are on record saying they do not want to lower earnings forecasts for stocks. They typically cite the fact that companies have steadily grown earnings, even when economic data weakens, like last summer, when economic data was so weak, the Fed began the bond buying program known as QE2.

Of course, many of those strategists and analysts were talking tough before yesterday’s 600 point decline on the Dow Industrials.

We should ask: where do those analysts stand now? Does that decline change anything for corporate America? Or was it an emotional reaction to the S&P downgrade and our frustrations with Congress?

It’s not possible to know the future (or I would have been holding a massive amount of put options), but to get an idea of what’s ahead, we should start with what just happened.

As you know, I run an investment research firm. It is my job to provide quality investment research. But it’s also my job to offer insight into what’s really driving the stock market and economy.

Because of my position, I hear from a range of investors. And I can tell you that the vast majority of communications I hear from my readers share two feelings: frustration with our political leadership and skepticism about Wall Street and investing.

I think the frustration aspect is pretty much self-explanatory. If you’re not frustrated, you’re not paying attention. But the skepticism has a different effect, one that I think has been especially evident lately.

To really get a handle on investor skepticism, we need to go back to the events of the Flash Crash of May 6, 2010. That was the day Wall Street trading was revealed for what it is: largely computer based trading that seizes on the market dynamics of the day and magnifies them to an outrageous degree.

Right now, computer based trading from institutions makes up around 70% of daily volume. That’s three-quarters of a day’s trading that doesn’t have the benefit of human judgment. And in the absence of human involvement, stock prices become the victim of self-reinforcing chain of "if-then" algorithms.

We now know that’s exactly what happened during the Flash Crash. And I will say that it’s a big part of what happened yesterday and last week.

So, on a day to day basis, investors are right to be skeptical, you are correct in that the market is manipulated. But in many ways, it always has been.

At the same time though, you can’t fool all the people all the time. In other words, fundamentals do come into play. In fact, over the long term, fundamentals do govern stock prices.

In especially bullish phases, we may see the S&P 500 trade to 17 or even 20 times expected earnings. In less bullish times like the ones we’ve been in, the multiple may be 13-16 times expected earnings.

Right now, the S&P 500 is trading with a forward multiple of maybe 10. That’s cheap, even if earnings estimates get lowered a bit. Could the stock market take another nosedive from this low valuation? Sure, but it would probably take some kind of external shock to the system. In the absence of any such shock, would any investors or traders want to be short stocks? I think not.

Now, let’s have a look at a couple stocks: Microsoft (NYSE:MSFT) and Northern Oil & Gas (AMEX:NOG). We all know cash rich Microsoft. It’s also one of the four American companies that has a triple-A rating.

Of course, like every other company, Microsoft got creamed over the last 6 trading days. But its decline stopped yesterday at $24.50, which is a pretty obvious support point on the chart. Microsoft is one of the most widely held stocks in the world. It’s buying back its own shares, and there’s a lot of speculation that it will offer another big one-time dividend, or raise its dividend.

There is little incentive – or ability – to really work Microsoft over. It’s attractive, and it’s one of the few stocks where buyers did step in yesterday.

As a polar opposite, there’s Northern Oil & Gas, one of my favorite Bakken oil stocks. It’s got a great business plan, excellent growth, and its tied to the one asset that best defines a bull or bear market – oil.

Oil prices have been killed over the last few days. Sure, growth exoectations have been tempered since the weak economic data started on July 27 with that bad durable goods number. But there’s no doubt that margin calls (or the fear of them) have exacerbated the drop in oil prices.

So, you might say Northern Oil & Gas was a vulnerable stock. And it got hammered yesterday, down 15% for much of the day. But a funny thing happened at the close. The stock dropped another $1.25 in the final minute of trading. And on very few shares, too.

This was simply the actions of a market taking advantage of a weak stock, and probably a few stop loss orders, too. But check Northern Oil & Gas today: it’s up $5 or 37% today.

My point? Stocks can get worked over in the short term when fear is in the air. But long-term, it’s the fundamentals that matter.

I wish I could tell you that it was all up from here. And I wish I could also tell you that computer based trading was about to get some restrictions applied to it. I actually think the latter is more likely than the former.

Now, one more point, and I’m done for the day. Regarding the frustration and skepticism of investors: I believe it all goes back to when President Obama refused to prosecute those who led us into the financial crisis. Investors needed to have closure, they (we) needed to know that wrongdoers would be punished, we needed heads on stakes.

And we didn’t get them. In fact, some of the same heads that might have ended up on stake are still at the heads of their respective companies.