Two Big Reasons to Believe the U.S. Stock Market Will Bounce Back

There's been a lot of cheerless news coming out of Europe lately, and that's taken a toll on the U.S. stock market. But I want to take this opportunity to offer up some positive points and remind investors that it's still too early to declare the bull-market dead, and even more premature to fret over a new bear market beginning.

There are two key considerations that support a continued rise in U.S. stocks:

1. Corporate profits have been strong and are likely to hang tough for the remainder of the year.
2. And the recent market decline has been in line with previous bull-market corrections.

Let's look at corporate earnings first...

Corporate Profits on the Rise

Recent developments in Europe have largely eclipsed a solid earnings season in the United States.

In fact, some 78% of the 477 companies in the Standard & Poor's 500 Index to report first quarter earnings have reported results above analysts' expectations. And as a result of increased profitability, the forward four-quarter price-to-earnings multiple for the S&P 500 now stands at 12.6 - well under the long-term average multiple of 15 and the average from the previous 52 weeks of 14.6. 

Obviously, the big question is whether these better-than-expected results will continue.

Well, according to new research by UBS AG (NYSE: UBS), the chances are high that they will. The Swiss brokerage says that unlike revenue forecasts, which can be accurately predicted based on gross domestic product (GDP) growth estimates, accurately predicting earnings growth during an economic recovery is hard because of the boost from operating leverage.

With cost structures cut so deeply, a 10% jump in revenue has a much larger impact on the bottom line as fixed costs are spread over a larger revenue base. So that 10% revenue jump can result in a 70% earnings jump. But unless one has intimate knowledge of a company's operations, it's hard to estimate that jump with any accuracy. That's why analysts have consistently underestimated earnings over the past few quarters. 

Now here's even more grist for the "just a correction" camp...

The "Just a Correction" View

Our friends over at Lowry's Research Corp. have told their institutional clients that the March 2009-April 2010 rally of 71% was the largest and fastest to follow a bear market in history. As a result, it generated an over-abundance of optimism, and thus deserved one of the sharpest and fastest corrections in history. Consider that the average 13-month rally at the start of a new bull market since 1942 has been 36%, or around half of the '09-'10 advance. 

Meanwhile, the current decline has amounted to a 10% decline for the S&P 500. Other major corrections within bull trends in the past fifty years included an April-Nov '71 decline of -16%, which then reversed to hit a new high two years later. And more recently, the Dow Jones Industrial Average fell 13% in the period ranging from Aug-Oct '07 and tumbled 11.5% from Aug-Oct '99. Overall, since 1960, there have been six corrections during bull markets of 10% or more, averaging just over 12%.

So, considering that the recent decline is within the limits of prior corrections, and follows a very overextended rally, Lowry's concludes that it's premature to believe that a new bear market lies dead ahead. Paul Desmond and his team believe that buyers will come back soon, and push the market to new highs.

One other timing view I'd like to throw at you comes courtesy of Bob Drach, a veteran investment researcher out of northern Florida who has shown an uncanny knack for calling bottoms over the past 30 years - and certainly in the past 12 years that I've been talking with him. He's not so hot with tops, but he typically nails nadirs.

Drach observes that tradable lows tend to form when more than 75% of high-quality stocks are lower than their levels of four weeks ago and a majority of his nine key data sets are positive. 

Using the S&P 500 as an imperfect proxy for quality, we can see that around 480 stocks in the benchmark index are down in the past four weeks, or 96%. And his positive data sets are U.S. Federal Reserve, macroeconomic, media, sentiment, professional positioning, non-professional cash reserves, technical and structural. 

Basically his model always leans in the opposite direction from the media and non-professional sentiment when prices reach extreme one-month lows, the Fed is accommodative, earnings are up, and professionals are net long in the futures pits.

Said the always-acerbic Drach this weekend: "There's nothing tricky. The data sets are basically monitoring the behavior of others for repetitive mistakes, usually emotionally induced. Basically, people are lured into beliefs that lack validity, and they manipulate themselves."

Well said. We'll take heed.

[Editor's Note: As the preceding market analysis demonstrates, Money Morning Contributing Writer Jon D. Markman has never been afraid to make a prediction.

What's more, Markman is usually right. With uncertainty the watchword and volatility the norm in today's markets, defensive investing is the way to go. However, given the competition, low-risk/high-profit investments will be tougher than ever to find.

Subscribe to Strategic Advantage and hire Markman to be your guide. For more information, please click here.]

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