It's ironic that the stock market suffered a huge "correction" only days before the second revision to Q2 GDP growth came in surprisingly strong. Sometimes the market gets carried away by emotions, and sometimes the economic statistics get revised significantly after the fact, so it pays to keep an eye on the fundamentals as revealed by key market-based prices (e.g., real yields on TIPS, swap spreads, the dollar, gold).
I've long argued that real yields on 5-yr TIPS were a good indicator of the market's expectation for the trend of real economic growth. As the chart above shows, the two tend to track each other over time. Real yields on 5-yr TIPS have moved quite a bit higher over the past two years, and now we discover that the economy strengthened over that same period. The annualized rate of economic growth over the past two years was 2.7%, a good deal better than the 2.2% annualized growth since the recovery started in mid-2009. .
Despite the pickup in growth, however, the economy is still a lot smaller than it could/should have been. As the chart above shows, the shortfall in growth relative to long-term trends is about $2.8 trillion. Per year. We're talking about a lot of income that's being left on the table, and a lot of people unemployed or underemployed, most likely because of higher tax and regulatory burdens.
Yesterday's GDP revisions also gave us the first look at corporate profits after tax for the second quarter. They reached a new nominal high of $1.82 trillion. As the chart above shows, that puts corporate profits very close to an all-time high relative to GDP. From a long-term historical perspective, corporate profits have been exceptionally strong throughout the current business cycle expansion.
The chart above shows the PE ratio of the S&P 500 using the after-tax corporate profits (with adjustments for inventory valuation and capital consumption allowances and normalized in order to facilitate comparisons to reported PE ratios) as the "E" instead of trailing GAAP earnings. By this measure, the stock market at the end of June was trading very close to its long-term average valuation.
What does all this say? The economy is doing OK, and has even managed to improve somewhat in recent years, despite all the moaning and groaning. Corporate profits have been absolutely fabulous, and certainly supportive of higher equity prices. Stocks aren't in a bubble, and monetary policy hasn't stimulated the economy or caused equity prices to artificially inflate.
So why is the market so worried? Why is the Fed so worried about the economy that they have to keep interest rates at zero? Sure, things could be a lot better, but we're not talking about a fragile economy that needs an extraordinary dose of TLC (aka low interest rates) to survive. If we want things to improve, we need to look to fiscal policy, not the Fed.