Why healthy corporate profits lead to a rally in stocks

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Why are corporate profits an important statistic?

The stock markets are mainly driven by investor expectations. However, there’s another substantial reason that could cause stocks to rally—strong corporate profits.

Strength in corporate earnings in a reflection of an uptick in business activity. This is also a major contributor to an economy’s gross domestic product (or GDP). As a coincident indicator, corporate earnings are a good measure of economic health. A growing economy will usually see—other things remaining constant—healthy corporate earnings reports coming out each quarter.

corporate profits
What does the current corporate profit reading say?

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The Bureau of Economic Analysis (or BEA) at the U.S. Department of Commerce released a report on August 28. U.S. corporations posted record profits during the second quarter. After-tax corporate profits—without inventory valuation and capital consumption adjustments—gained an annualized 26.5% in the second quarter. This increased the seasonally adjusted annual rate of $1.840 trillion—after an 11% drop in the first quarter. On a year-over-year (or YoY) basis, after-tax corporate profits were up 4.5% in the second quarter—compared to 2.4% in the first quarter.

Market implications

The second quarter corporate profits’ reading suggests that companies in the U.S. are leading the economy into its growth trajectory. The U.S. economy is recovering from its recessionary phase. Its five most valuable companies are reporting record profits.

Apple Inc. (AAPL)—the most valuable U.S. company—reported a 28.84% operating margin in the recent quarter on a trailing 12-month basis. Google (GOOG) and ExxonMobil (XOM), the second and third most valuable companies, reported 23.41% and 11.24% in operating margins on a trailing 12-month basis in the recent quarter. Exchange-traded funds (or ETFs) like the SPDR S&P 500 ETF (SPY) and the Vanguard Total Stock Market ETF (VTI) are invested in blue-chip stocks.

Improving GDP and corporate profits all contribute to increased investor confidence. The economy was negatively impacted by the credit crisis in 2008. However, it has recovered well enough to increase the S&P 500 Index. The S&P Index gauges the market. The Index went from below the 1,000 index points level back in 2008–2009 to above the 2,000 index points level on August 26, 2014.

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