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What Q3 Earnings Season Shows Us About Today's Stock Market

If you want more evidence that the U.S. stock market is disconnected from the actual economy, you only need to look at its performance during the third-quarter earnings season. Since earnings season began in early October, the Standard & Poor's 500 Index , Dow Jones Industrial Average , and NASDAQ Composite Index have climbed 5.7%, 5.2%, and 6.1%, respectively. The S&P has recently closed with consecutive record highs for four trading sessions and ended above the previous close on 13 of the last 17 trading sessions. But the actual earnings results don't support this trend.

If you want more evidence that the U.S. stock market is disconnected from the actual economy, you only need to look at its performance during the third-quarter earnings season.

Since earnings season began in early October, the Standard & Poor's 500 Index, Dow Jones Industrial Average, and NASDAQ Composite Index have climbed 5.7%, 5.2%, and 6.1%, respectively. The S&P has recently closed with consecutive record highs for four trading sessions and ended above the previous close on 13 of the last 17 trading sessions.

But the actual earnings results don't support this trend.

As of Oct. 25, 244 companies had reported results. In terms of revenue, 52% reported sales above the mean estimate, below the four-year average of 59%, according to FactSet's Earnings Insight. About 75% reported earnings per share above the mean estimate, only slightly above the four-year average of 73%.

Companies, however, only beat earnings per share estimates by about 0.8% on average, drastically down from the four-year average of 6.5%.

There is a widening disconnect here between the sluggish American economy and the frenetic performance of the U.S. stock market. Money Morning Chief Investment Strategist Keith Fitz-Gerald calls this disparity "fundamental expansion."

"What this means is that the market is pricing in anticipation rather than real results, as it has done traditionally," Fitz-Gerald told Money Morning. "The markets are getting ahead of themselves."

When we look closer at the results of this earnings season, we see a different story than what the market is telling us...

Expense Reduction, Not Revenue Growth

Earnings growth this quarter remains more about cost cutting than it does about the economy at large, says Fitz-Gerald. Earnings keep going up, but revenues aren't keeping pace.

"Almost without exception, what we're seeing is gains in expense reduction without strong top line growth. If this were a real recovery, we'd be seeing strong top line growth, not just expense reduction," says Fitz-Gerald.

In other words, companies are showing increased earnings by doing more with less. While they're getting leaner and meaner, they're not really growing.

But they're getting very good at looking like they are...

"I'm surprised, frankly, by the resilience with which corporations have been able to maintain their earnings growth in the face of increasingly repressive regulation and Federal Reserve meddling," says Fitz-Gerald.

Earnings growth unaccompanied by strong revenue growth means the economy that underlies both stock and corporate performance is not as strong as the stock market seems to think. And one important economic indicator agrees: consumer spending.

"Consumer spending and stock market performance are badly out of line with each other," says Fitz-Gerald. Consumer spending has risen 9% since Q2 2009. The S&P 500, on the other hand, has risen 116% over the same time period. Consumer spending makes up around 70% of the U.S. economy and is considered a proxy for economic expansion.

The divergence doesn't necessarily mean that a serious market correction is in the offing, Fitz-Gerald cautions.

Rather, it provides more evidence that the Federal Reserve is fueling the stock market's rise. Cheap money looking for return is what's driving share prices - not solid economic performance.

This Fed-driven market bubble will keep going into 2014 with the addition of Janet Yellen as Fed chief.

Still, she will have a choice regarding whether to continue Ben Bernanke's easy money policies, says Fitz-Gerald. "Either Yellen has to continue to stimulate everything, or we have a correction as prices come down to a supportable level. She's probably getting her helicopter pilot's license right now."

Whether it's the U.S. stock market, subprime mortgages, or Dutch tulips, bubbles always pop. Even if the correction is still a way off, Keith Fitz-Gerald has some great advice to help you protect your assets now...

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