Further supporting the idea that a correction is likely to be shallow, we're seeing better-than-expected economic readings, including:
- Stronger retail sales
- Increasing small business optimism
- A downside breakout in unemployment claims
- Stronger money supply growth
- Improved consumer confidence
Earnings and valuation remain supportive
Thanks to rebounding economic fundamentals, we have yet another earnings season to cheer. In fact, it was the seventh consecutive quarter in which earnings were better than consensus expectations, after a string of five consecutive quarters in which earnings sorely underperformed expectations.
More than 90% of the S&P 500's companies have now reported third-quarter earnings. The upside surprise relative to the consensus of bottom-line earnings was 6.8%, which is lower than the 9.9% surprise factor in the second quarter. However, the top-line revenue surprise of 0.9% was higher than the 0% number in the second quarter.
Slightly fewer companies reported higher earnings year over year in the third quarter than in the second quarter, but more companies had higher revenues. It was necessary to begin to see both top-line and bottom-line gains to assuage concerns that earnings growth was strong solely due to cost-cutting.
Valuation on those better earnings remains in decent territory, with the price-earnings ratio (P/E) on five-year normalized earnings back down closer to its long-term median of about 17. And in light of still-low inflation, the market looks relatively cheap: In the 1-3% inflation zone in which we presently sit, historically the market has supported a P/E of about 20.
In sum, not a bad story
My best guess as to the scenario that is unfolding is that the economy is gaining traction, which could cause the Federal Reserve to pull QE2 into the dock sooner than expected. It could also lead to a lift in the dollar, a related pullback in commodity prices, and rising bond yields.
Given the high correlation recently between bond yields and stock prices, if yields were to continue to rise, they could take stock prices up with them; especially if the reasons are a better economy and lessened deflation fears.
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