The great credit squeeze of August last year had a nearly immediate effect on corporate profits, hitting financial firms so hard that the group pulled total profits for all corporations to year-on-year declines. Corporate profits based on the S&P 500 and as measured by First Call, declined a year-on-year 4.5 percent in the fourth quarter to end five straight years of outstanding growth. With half of the first-quarter earning season in the books, profits are down 13.9 percent. As seen in the graph below, profits are expected to decline again in the second quarter before turning higher, and turning higher in a spectacular way beginning in the third quarter.

The trouble is isolated — so far at least — to the financial sector excluding which, profits would be continuing to expand, showing year-to-year growth of 11.7 percent in the fourth quarter and 8.7 percent according to the early data for the first quarter. But trouble at financial firms is squeezing credit to borrowers both commercial and individual, and clearly posing a risk to other sectors. Many statements from non-financial companies this earnings season include comments on the inability to secure (what had been expected) financing for everything from acquisitions to general corporate purposes. Some companies are also taking write-downs on their own portfolio of credit instruments, including government-backed securities from federal agencies.

The trouble, in a more delayed fashion, has widened out to the stock market. The S&P index, as seen in the graph below, posted a small year-on-year gain in fourth quarter but did contract in the first quarter and is also showing a small contraction in early days of the second quarter. Stock prices have lagged profits throughout the expansion, showing declines early on for five straight quarters in 2002 and 2003 even while profits were moving ahead and then exceeding profits for another five straight quarters in 2006 and 2007 even while profits began to contract. As of this writing, the S&P for April is down 6 percent year-on-year, indicated by the last red bar on the right of the graph. Profits have not been supporting share prices for more than a year, an unsustainable disconnect between profits and shares that hints at big losses in the stock market should the big expectations for future profits fizzle out. Even if companies do meet the expectations, stock prices are not necessarily going to follow higher right away.

The 6 percent decline in April in part reflects disappointment in the current earning season, which up until a few weeks ago had been expected to show growth. Fittingly, General Electric, a giant conglomerate, set the tone early on in the season, warning in early April that its consumer and finance businesses were seeing weakness that was more severe than expected. But GE is also a top industrial manufacturer and these businesses continue to do well as are the nation's other industrial manufacturers which continue to benefit from global infrastructure development, multi-year lead times for their products, and of course the ever more competitive dollar that is making their products less expense than those of foreign competition. For the U.S. economy as a whole, however, industrial goods make up less than 10 percent of GDP.

Foreign demand has also helped the U.S. stock market. Despite contracting profits, despite declining shares, and despite a negative currency effect, foreigners continue to invest in the U.S. market, at least up until February which is the latest data available. The graph above tracks net foreign purchases of equities and shows solid demand, even though the last two bars at the right of the graph, representing January and February, do show slowing. But the big contraction in August, represented by the red bar that shows a more than $40 billion outflow for the month and which badly rattled nerves on Wall Street, has not been repeated, not even marginally. How long foreigners will keep buying U.S. stocks is an open question.

The state of the stock market is not the only measure of the population's assessment of the economy. Consumer confidence measures ask us specifically about our views, and yesterday's Conference Board report set a run of records — all negative. The graph above tracks the consumer confidence index against corporate profits, and the results are similar to the comparison with stock prices. Consumers were still pessimistic in 2002 and 2003 even while profits were expanding, due to what was then slow recovery in the jobs market which itself is a lagging economic factor as companies, even as an expansion takes hold, hold back on hiring as long as they can. But consumer confidence then continued to rise, hitting a peak in mid-2007 at time when profit growth had already been slowing for a full year. The current confidence drop though does match up with the contraction underway in profits.

Bottom line

Corporate profits offer one of the first readings of trouble in the economy, showing contraction well before stock prices and sounding a sharper, quicker alarm than traditional economic data such as retail sales or GDP. For the general public, the stock market is the headline data for the economy. If corporate profits continue to contract, especially if non-financial sectors begin to show contraction, the outlook for the stock market will turn south in turn feeding expectations of overall economic contraction.