By Michael Lewitt, Editor, The HCM Market Letter

As we enter the second half of 2010, it is increasingly clear that the S&P 500 is unlikely to return to the 1200 level HCM anticipated earlier in the year. HCM now expects the index to remain in a lower trading range for the remainder of the year bounded by 975 on the downside and 1150 on the upside (admittedly a wide range, but this is a volatile market driven by computers). Based on the sharp drop in Treasury yields, we expect the market to occupy the lower rather than the higher end of this range. The markets are wrestling with the reality of slow growth in the U.S. and Europe, a relapsing housing market, public and private deleveraging, higher taxes in 2011, more regulation and an increasing acknowledgement that our political and business leaders are hollow men.

HCM’s new target range is decidedly lower than the 1250-1275 range set earlier in the year, when we expected market momentum to carry the S&P higher than the economic recovery justified. Obviously the earlier view was wrong. But the Greek crisis coupled with the BP oil spill have focused the market on the fact that the economic recovery was largely a product of government stimulus and not organically based. HCM remains unconvinced that the economic data is pointing to a sustainable or organic economic recovery, and is therefore lowering its stock market target even though the stock market is inexpensive by historical measures.

A survey of 2000 economists by Bloomberg forecasts S&P 500 earnings to come in at $81.27 in 2010, so a 1200 level on the S&P 500 would be a very reasonable (indeed historically low) 12x if earnings materialize as expected. Nonetheless, we still don’t think we will get there by year end.

The market is telling investors that both the economy and corporate earnings are going to slow down in the second half of 2010. HCM is inclined to believe that corporate earnings will come in on target because corporations have taken significant steps to lower their cost structures and their interest costs are quite low. At the same time, we believe economic growth will be extremely sluggish and that the possibility of a return to negative growth must be taken seriously

As noted above, we do not expect corporate earnings to be the problem. If the economy does experience a double dip it would not be until the first or second quarter of 2011. Fears of a double dip are one obvious factor influencing the market to place a lower multiple on earnings than in the past.

But there is another non-fundamental factor that is depressing stock prices: the hegemony of quantitative/computer trading. When investors watch stock prices move dramatically without any identifiable reason related to the fundamental business operations or results of a company, it destroys confidence in basic market processes. We are still waiting for a satisfactory rationale or explanation of the May 6th 1000-point plunge in the Dow Jones Industrial Average. Unfortunately, we will probably be waiting another 1000 years because we are looking in the wrong place if we are expecting a fundamental or rational explanation.

The reason the market plunged was entirely based on the operations of the computer programs that dominate today’s markets. The answer lies buried within the algorithms of the trading firms that have been permitted by our toothless regulators to dominate modern markets. This has destroyed confidence in basic market mechanisms even among the most sophisticated and experienced traders, not to mention John Q. Public. This type of price action is also inimical to capital formation, which dries up in volatile markets like today’s.

As HCM has written many times (although we were unable to include a chapter on quantitative trading in The Death of Capital because of our publishing deadline), computer-driven trading strategies are the epitome of speculation and add nothing to the productive capacity of the economy. Instead, they are inexorably destroying confidence in the capital markets and diverting intellectual and financial capital into activities that enrich a small elite at the expense of the rest of society. Moreover, many of these activities are little more than legalized theft. Our regulators, politicians and business leaders (in particular those who engage in this noxious activity) are harming the rest of society by allowing these activities to continue. They must be regulated out of business as soon as possible.

*(Reprinted with permission of The HCM Market Letter)