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This week kicks off earnings season in the market. Even though we go through it four times a year, it’s a time when investors should be paying extra attention.
Earnings are important because ultimately, fundamentals are the only thing that matter. When you get down to it, a share of stock is worth nothing more than the future stream of cash flows that it will generate. During the tech bubble it became fashionable to ignore earnings altogether because there weren’t any. Someday, everybody said, the earnings would be HUGE!
So let me revise that: earnings aren’t the only thing that matter.
There is also psychology.
The way that psychology factors into the market is that investors are willing to pay different prices today for earnings in the future. When they’re feeling really great, they’re willing to pay a lot for $1 of earnings. When they’re scared or pessimistic, they aren’t willing to pay much for that $1.
You’d think that psychology would be a difficult thing to measure quantitatively, but it really isn’t. You simply look at the price-to-earnings ratio. That will tell you exactly how much investors are willing to pay for that dollar of earnings, and when you relate that to historical P/E ratios, you can get a pretty good sense about the psychology of the current market.
We talked a bit about this last week, but some of this is worth repeating. In particular, there are two images you really need to make sure you understand.
This is the first:
This is a list of one-directional markets i.e. bull markets without any kind of significant correction or cyclical bear market. All of them eventually ended with a nasty down move. Nothing goes up forever, of course. But as you can see, some ran longer than others.