The subprime effect has yet to tilt the economy into recession, but it has badly hurt the financial sector and is pulling down most economic indicators in what will be an obvious patch on future economic graphs. And the duration of the effect is growing, now nearing six months — which is perhaps too long for it to be defined as a shock. For graphs, recession bars won't be allowed at least for now, but something like it isn't a bad idea.

The graph below, data courtesy of First Call, tracks S&P 500 profit growth during what is still the 2002 expansion. The green bars to the left depict 21 straight quarters of profit growth, mostly in double-digit percentages. The two red bars on the right are pointing down, depicting two straight quarters of profit contraction (bad but still much better than losses). With about one quarter of the earnings season completed so far, profits are down a year-on-year 20.4 percent.

Dismal, right? No! Excluding financial firms the fourth quarter would be another double-digit gainer at 11.7 percent. And the 11.7 percent rate is a big improvement from the 3.0 percent ex-financial growth rate of the third quarter — a result that points to profit acceleration in the bulk of the economy. Acceleration is what the last two bars on the above graph really show. Wall Street is pegging third quarter profit growth this year at an oversized 20 percent and fourth quarter growth at more than 50 percent with both readings inflated by easy comparisons against recent quarters.

The graph above matches up the green and red bars in the prior graph, which again are profits, with yellow bars which are year-on-year change in the S&P 500 index. The graph offers a look at stocks relative to profits. Profit growth was well ahead of share price growth through most of the expansion — that is until the last five quarters when shares have exceeded profits and continued to grow even as profits contracted. But share prices have fallen steeply so far in the first quarter and may once again begin to lag profits, especially if profits bounce back as Wall Street expects.

The graph above compares stocks with a second, less timely measure of profits compiled by the Commerce Department. The red line is the S&P 500 index against the black line of after-tax corporate profits. The black line rises at a steeper rate through much of the right side of the graph but has since slowed to more or less match share price growth, results that confirm the First Call comparison. The break lower in both lines in 2007 is an example of the etching that the subprime effect is having on economic graphs.

Bottom line

The earnings season is just underway and continued bad news from financial firms, including many thrifts and mortgage companies that have yet to post their data, are certain to feed risk-aversion trades and disinvestment from the stock market. But keep an eye on non-financial companies and whether their statements reflect optimism in their markets. FOMC policy makers are always hesitant to refer to profit growth or especially share prices, but watch for indirect references in their statement this afternoon.