Thursday, July 26, 2007

The Pause that Refreshes

In the midst of this hurricane-strength gale force wind of stock market pessimism, permit me to offer a very basic, positive view of stocks.

Corporate profits are the mother’s milk of stocks and the economy. They are also the ultimate backstop and guarantor of the quality of credit.

Amidst this panicked obsession about market downgrades of corporate and housing debt, the fact is that with 50% of the S&P 500 companies reporting (as of the close of business last evening) market cap-weighted profits are up 15.3 percent.

That is roughly three times the consensus expectation for the 2nd quarter.

Meanwhile, positive earnings surprises are virtually identical to those in the first quarter, while negative surprises are almost 6 full percentage points less than the first quarter.

So, while the bond market instructs private equity buyout firms to stop their over-leveraging of debt and go back to equity issuance in their takeovers, the key point that many people are missing in this market correction is that profits are robust and stocks remain relatively cheap.

Not only are stocks relatively cheap in relation to stronger than expected profits, but the decline in the Treasury bond rate that is used to discount the present value of future earnings makes stocks even cheaper still.

The moral of the story is that intelligent investors should be shorting toxic bonds—whether they are corporate or mortgage backed—and buying valuable stocks as they correct lower. The dynamic U.S. economy is on solid ground as is much of the global economy. Goldilocks is alive and well, so long as Congress doesn’t muck it up.

As for corrections, they come and go. This one is the pause that refreshes.