How Record Profits Are Fueling the Bull Market

The corporate earnings season for the third quarter is already off to a strong start. Investors are watching these reports closely as concerns over supply chain bottlenecks, the delta variant, rising rates, and other factors threaten company bottom-lines. Although markets have been more volatile in recent weeks, strong profitability has helped the stock market gain over 20% with dividends this year. What can investors expect from corporate profits in the quarters ahead?

Earnings fully recovered from the pandemic lockdowns during the second quarter of the year, rising alongside the broader economy. Third quarter earnings will likely show that S&P 500 companies generated about $185 per share over the previous twelve months, a significant recovery from $133 at its worst point. Full-year 2021 could see $197 per share which would represent an astounding 46% growth rate. Profits are then expected to grow nearly 10% each of the next two years.

If this occurs, it would be good news since earnings are what drive the stock market in the long run. This is because investors don't invest in the economy directly. Instead, when the economy grows, companies generate more revenues which can funnel down to greater earnings. This, in turn, supports stock prices over time. So, although investors tend to focus on day-to-day market moves which are driven by multiples, long-term profits are what provide the foundation on which stock markets rise over years and decades.

Even sectors which had been left behind the past several years have seen a rebound. The energy sector, for instance, had struggled due to an oversupply of oil and gas prior to the pandemic. With energy prices now at multi-year highs, energy sector profits are expected to reach their highest levels in over three years with the fastest growth rate for the S&P 500. In fact, all eleven sectors are expected to experience positive earnings growth with industrials and consumer discretionary rounding out the three fastest groups.

The big question that investors will seek to answer is whether on-going supply constraints will impact corporate profits in future quarters. So far, it's been an industry-by-industry story with bottlenecks occurring alongside higher prices for final goods and services, thus offsetting their broad negative effects. It's fortunate that the average consumer is in a strong financial position which has allowed them to absorb higher inflation rates. This can only continue if supply issues are resolved quickly and current inflation rates prove to be "transitory."

Ultimately, investors should continue to focus on earnings and valuations since, in the long run, they are what drive stock market returns. Although there are always uncertainties, history shows that those who are able to stay invested throughout the business cycle can improve their odds of financial success.