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Reading the bond and stock market tea leaves

Today's deeply disappointing GDP report has helped 10-yr Treasury yields to their lowest level of the year, and there's little doubt that the problems Congress is having over increasing the debt limit are contributing to the market's malaise. As my chart suggests, the current level of 10-yr yields is indicative of a market that expects a recession. The last time yields were this low or lower the market was last summer, when concerns about a double-dip recession were rampant.

10-yr yields are strongly influenced by the market's expectation of the future path of the Fed funds rate, and with the economy so weak and expectations for future growth so dismal, the market is now expecting the Fed to keep rates near zero throughout this year and most of next year; in fact, the market currently doesn't see much chance of any meaningful Fed tightening until the first half of 2013.

Are the bond and stock markets out of synch? Bonds are priced to a recession, but the S&P 500 is only 5% below its recent highs, and over 20% above last summer's lows.

These two charts help explain what's going on. As a result of the recent revision to the past several years of GDP, corporate profits were revised to be much higher than before. First-quarter after-tax profits (which are based on corporate tax filings from the IRS) are now reported to be running at an annualized rate of almost $1.45 trillion, compared to the $1.26 trillion previous estimate. Relative to GDP, corporate profits are now at a new all-time high. Even though the recovery that began two years ago has been downright dismal, corporate profits have surged by almost 50% to record-setting highs.

Using NIPA profits as a proxy for all corporate earnings and the S&P 500 index as a proxy for the value of corporate equities, I've constructed the chart above. This shows that PE ratios have rarely been so low in the past 50 years. The market may be depressed by the economic outlook, but it's hard to ignore $1.5 trillion of corporate profits. If anything is sustaining the level of equity prices today, it's profits, not optimism. As a result, for those who believe that the debt limit will be raised and fiscal policy will improve—even marginally—current valuations represent real bargains.

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