As earnings improve, stocks are getting cheaper

Traders on the floor of the New York Stock Exchange.
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Traders on the floor of the New York Stock Exchange.

A glance at a chart seems to indicate that stocks are expensive. After dropping 4.3 percent from high to low, the S&P 500 is nearly back to record levels. And as bears delight in pointing out, the market has not suffered a 10 percent correction in more than two years. But according to one simple measure of market valuations, investors who buy stocks now are getting a much better bargain that those who bought earlier.

In 2014, "different than 2013, the move higher is driven primarily by an improving corporate outlook than a re-rating of market multiples," writes RBC chief U.S. market strategist Jonathan Golub in a Monday note. "In fact, forward P/Es [or price-to-earnings ratios] have actually contracted modestly, making stocks a more attractive purchase."

Translation? Investors are paying less for every dollar of expected earnings.

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As for reported earnings, they have come in above expectations. According to FactSet, of the S&P 500 companies that have reported their second-quarter results, 73 percent have beaten analyst earnings estimates and 64 percent have beaten revenue estimates. That means that while analysts on the whole were looking for earnings to grow 4.8 percent in the second quarter, so far we've seen a blended growth rate of 7.6 percent.

And with companies beating expectations, analysts have responded by raising their estimates of the earnings that companies will report in the future.

"Over the past four months, estimates have begun to rise for 2014. Higher estimates are likely the result of stronger management guidance and greater analyst confidence. We believe this is a bullish sign for equities," Golub writes.

Of course, not everyone thinks the trend in earnings will continue. Jim Iuorio of TJM Institutional Services, for one, says it is easy to underestimate the role of the Federal Reserve's ultra-low interest rate policy in boosting corporate results.

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"A significant part of the good earnings story is due to very low borrowing costs," Iuorio said. "If the market starts getting a sense that the days of dirt-cheap money are nearing an end, they will take it out on stocks regardless of the relative value based on P/E levels. My point is that, although P/E is relevant tool for predicting stock market direction, we are at a time when other factors are far more important."

For Fed-focused traders like Iuorio, any more-hawkish-than-expected comments in Fed chair Janet Yellen's speech at Jackson Hole, Wyoming, on Friday morning could easily outweigh any trend we've seen in earning growth.

—By CNBC's Alex Rosenberg.

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