Larry Kudlow

Stock market bulls like myself were on the losing side of this week's trading, as the Dow gave back roughly 4 percent from its 14,000 peak. The big story was a wave of high-anxiety credit fears over the value of corporate and housing loans. Credit circuits blew a fuse, lending markets temporarily froze, and a number of buyout deals were postponed as analysts and traders worked through their problems.

But this is no time to lose faith. The economy has found its legs with a 3.4 percent GDP growth report for the second quarter, a much-needed surge from only 0.6 percent in Q1. Moreover, core inflation came in at a rock bottom 1.4 percent.

Most importantly, second quarter corporate profits are flowing in two to three times better than expected. Much of this reflects the huge global economic boom that Treasury Secretary Henry Paulson describes as the greatest worldwide surge in his professional lifetime. These rising profits inject new value into the stock market.

Doomsday seers on Wall Street take notice: At 15 times forward earnings, the S&P 500 yields about 6.5 percent, a very high equity risk premium compared to a 4.8 percent yield on 10-year Treasury bonds.

Be it loan worries or the stock correction, the key point in all this is the steady stream of rising profits. Profits matter. They are the best guarantee for the credit worthiness of corporate loans and the value of stocks.

As classical economist Benjamin Anderson wrote in the 1920s when he was the top economist at the old Chase National Bank, "Profits are the heart of the business situation." Down through the years, I've paraphrased that as profits are the mother's milk of stocks and the economy. It's time to add creditworthiness to that list.

What we're witnessing is not a true credit crunch, but a temporary credit freezing-up. Banks have a lot of loans from financing buyout deals, and right now the credit freeze has stopped them from selling these loans to institutional customers. Loan markets have been over-leveraged by private equity funds that during the past year or so have completed deals with too little cash equity and too much loan leverage.

Bond vigilantes are disciplining the buyout mavens and forcing a credit risk re-pricing that will incentivize cash equity and discourage debt over leveraging. It's a healthy market-driven correction. The key point is that robust business profitability makes these over-leveraged bank loans good paper, not bad. In due course, the dust will clear and credit markets will resume functioning. Bankers will divide up these loans and resell them in tranches at handsome interest rates to pension funds, insurance companies and money managers around the world.


Larry Kudlow

Lawrence Kudlow is host of CNBC’s “The Kudlow Report,” which airs nightly from 7 p.m. to 8 p.m.