The facts don’t line up with the media coverage, however. Year-to-date through July, the S&P 500 has returned 11%. After a great start to the year, the index swooned in May, falling 6%, but solid returns in June and July erased almost all that decline. In the first couple of weeks of August the index has posted further gains.

Why is the market advancing? The answer seems to be that things aren’t great but they aren’t particularly terrible either. As of August 10, 447 companies in the S&P 500 have reported second quarter results. While most analysts expected flat earnings growth for the quarter, these companies’ earnings have actually advanced 5.5%. While this isn’t as strong as the double-digit growth we have been enjoying in this recovery, as long as earnings are advancing there is room for the market to do so as well.

The economic climate for these companies continues to be slow. Second quarter U.S. GDP advanced 1.5%, down from 2.0% growth in the first quarter. We seem to be stuck in the range of 1%-2% growth, about half the 3%-4% growth rate we had become used to since the early 1980’s until the start of the 2008/09 recession. A more worrisome reading from the second quarter report was the tepid 1.2% advance in real final sales, a proxy for consumers’ appetite to spend.

However, there were some bright spots in the GDP report. Inflation, as measured by the price index deflator, increased only 0.7%, down from 2.5% in the first quarter. A reduction in energy costs played a big role, but even excluding the volatile food and energy categories the price index deflator advanced only 1.4%, down from 2.4%. Unfortunately, higher inflation readings may return in future quarters due to the impact on food prices from the summer drought and a rebound in energy costs from a price spike in gasoline caused by temporary refinery shutdowns. But in the meantime, these low inflation readings provide leeway for the Federal Reserve should it wish to provide further monetary stimulus.

Another piece of good news from the report is the continued steadiness of income growth. Real personal disposable income grew 3.2%, down only slightly from the 3.4% reading of the first quarter. Income growth is important to the economy since it provides the cash necessary to increase spending in the future.

Employment growth in July snapped back from the weak readings of the second quarter. 163,000 jobs were added during the month, while the unemployment rate edged up slightly to 8.3%. The government sector cut back on job losses to only 9,000 for the month. While this growth is welcome, we will have to wait and see if it can be sustained in the coming months since July was positively impacted by lower than normal summer shutdowns of several domestic auto plants.

There has also been some good news recently from the housing market. According to Zillow, Inc., home prices for the second quarter rose for the first time since 2007, up 0.2%. Prices are beginning to reflect the impact of ultra-low mortgage rates and a decline in inventory, particularly foreclosed properties. CoreLogic Inc., another firm that tracks housing data, reports a year-over-year price advance of 2.5% for June, and that 71 of the nation’s top 100 metropolitan areas saw prices rise year-over-year in May. The housing sector has been a consistent drag on economic growth but appears set to begin making contributions going forward.

The impact of slowdowns in the global economy, particularly Europe and China, should not be dismissed. However, they should also not be overemphasized. U.S. exports account for roughly 15% of GDP. Even a sharp drop in economic activity of 5%, about the same as the harsh contraction the U.S. experienced in 2008, would shave about 0.7% from U.S. growth. Given our slow growth rate of 1%-2%, this level of decline would surely be felt but it would not be enough to push us into a recession.

As long as companies see some economic growth they can continue to grow earnings, the only driver that matters to stock prices in the long run. We have never advocated market timing and we certainly don’t see this as the time to start, particularly when the U.S. economy is continuing to grow.

- August 24, 2010