Wednesday, July 25, 2007

Goldilocks Still Strong

Yesterday’s stock sell-off is no cause for alarm.

Some important things to consider:

Second quarter profits are coming in around 7 percent while 10-year bond rates remain slightly below 5 percent.

After-tax GDP profits based on IRS taxable income (nobody overestimates IRS-taxable profits) have increased 130 percent since the 2001 recession low. Meanwhile, the DJ Wilshire 5000 has gained 109 percent. Simply put, profits have risen more than stock market averages.

Despite credit and loan quality worries, junk spreads remain historically low at around 335 basis points. (The junk spread was over 1,000 basis points in 2002.) So while there's a move toward higher risk premiums in the loan markets, it still looks containable.

Long-term interest rates and capital investment tax rates are lower today than they were six years ago.

The price earnings multiple for the S&P 500 on a trailing 12 month basis at the peak of the Internet boom was 46 times. Today’s S&P 500 on the same basis is a much more modest 18 times earnings.

The Fed will keep the fed funds rate target on hold at 5.25 percent for the foreseeable future.

The economy is coming back from a first quarter rough patch. Believing as I do that stocks are determined by earnings and interest rates, the market still looks cheap, though it is not nearly as cheap as it was one year ago.