Economic numbers coming out this week should be reassuring on the issue of the recovery.

Consumer confidence, due out on Tuesday, should rise in line with gains seen in other consumer surveys, while both the Chicago and national purchasing managers’ surveys should show continued improvement in manufacturing.

Even lower-than-expected inventories in June should prompt a downward revision to second quarter GDP, increasing the peak-to-trough output decline in the recession to an even 4.0%. Vehicle sales likely fell heavily in September from August due to the end of the “cash-for-clunkers” program, and the pending home sales index may have slipped back following strong gains in recent months.  However, over the next year, inventories, auto sales and housing starts should all resume a path back to normal levels which will be a powerful source of economic growth.

Finally, the unemployment claims data, due out on Thursday and the September jobs report due out on Friday should confirm that the pace of job loss is continuing to ease.

The impact of a turn in the economy should be evident in earnings reports over the next few weeks.  In the second quarter, positive earnings surprises outpaced negative surprises by more than a 3 to 1 margin and with earnings estimates rising strongly going into the earnings season, S&P500 firms ought to be able to beat the roughly $14.50 expectation for 3Q earnings.  Indeed, the next few quarters should see very positive earnings trends given low wage and interest costs and improving revenues.

A steady trend of improvement, however, should be more ominous for Treasuries, as super low real yields (such as 1.6% on a 10-year TIP) seem out of whack given the prospect of an improving economy and ballooning government debt.

Technically, the stock market may be overdue for a correction and there are plenty of domestic and geopolitical issues which could trigger one.  However, for investors, the prudent course is probably to regard continued recovery as the most likely scenario and invest in a way to take advantage of it.

David Kelly is chief market strategist for J.P. Morgan Funds.

Housing starts should be close to flat following some recent strong gains and unemployment claims could back up a little after a very welcome 26,000 drop last week. Inflation measures should be relatively benign, with few price pressures outside of the always volatile energy area.

For the U.S. economy, and indeed economies around the world, the start of the recovery appears to be unfolding relatively smoothly.  Having said this, given the depth of the recession it will take years to get back to full employment and deflation rather than inflation seems to be the greater threat.  Importantly, the case for a “new normal” of unusually low economic growth is still unproven – credit is tight but may well loosen as the economy expands while on the supply side productivity growth remains solid as is the long-term growth of the labor force.

However, for a while at least there may be a “new normal” when it comes to how investors perceive risks and react to volatility.

Treasury interest rates appear much too low and will likely move higher. But the very fact that people will buy Treasury bonds with such paltry yields speaks to the very risk-averse nature of investor attitudes at the end of a long and turbulent decade.

Equally, future earnings prospects, should justify further stock market gains even given the extraordinary advances of the last six months. But it may well be that stocks have a hard time getting back to a normal relationship with long-term earnings, given the repeated disappointments meted out by the stock market over the last decade.

In other words, for now, the recovery trade, whose major theme is being overweight stocks and underweight bonds, with minor threads of being short the dollar and long commodities still seems appropriate. However, the limits of this trade are very difficult to gauge, given the potential impact on investor behavior of the last extraordinary year.

David Kelly is chief market strategist for J.P. Morgan Funds.

• Manufacturing is improving which should be confirmed by increases in the Chicago Purchasing Managers Index on Monday and the national ISM survey due out on Tuesday.  Indeed, Tuesday’s number could show the manufacturing sector growing for the first time since January of 2008.
• Housing is continuing to improve which should be indicated by an increase in the Pending Home Sales index due out on Tuesday, although the increase may not be as strong as the more than 3 index point jump seen last month.
• Auto sales, also due out on Tuesday, should have increased sharply in August reflecting the impact of the “Cash-for-Clunkers” scheme.  Its worth noting, however, that just replacing the number of vehicles normally scrapped in the course of the year and finding vehicles for the growth in the driving-age population implies a trend sales rate of over 15 million units.  Because of this, contrary to popular opinion, Cash for Clunkers should not have stolen too many sales from the future, and while sales will likely relapse in September, they should begin to grow again in the fourth quarter, and,
• The labor market should show further signs of stabilization on Friday, with the monthly job loss potentially falling below 200,000 for the first time in almost a year.  However, even in a best-case scenario, the unemployment rate is likely to move up from the surprise drop to 9.4% last month.  These forecasts, however, are nervous ones, as initial unemployment claims remain stubbornly high for a labor market which is suppose to be about to turn a corner.

The second quarter earnings season is behind us but analysts’ estimates for earnings for the rest of the year continue to move up sharply, presumably reflecting company-specific data.  While rising earnings are a positive for the stock market, rising deficits should be a negative for the bond market.  Last week’s very sobering mid-year review of the budget from the Office of Management and Budget projects a colossal $9 trillion in cumulative deficits over the next decade.

Overall, while there are many risks to the recovery, a growing economy and growing national debt still seem to favor overweighting stocks and underweighting bonds.

David Kelly is chief market strategist for J.P. Morgan Funds