Search for the market truth

The following is an excerpt from a very good economist I follow:

stock prices have now fully anticipated a strong recovery in the economy. With the S&P 500 now trading at over 19 times prior peak earnings, stock prices now reflect the same valuations seen in 1929, 1965, 1972 and 1987, exceeded only in the advance to the 2000 extreme. On any other measure than earnings, valuations are higher than any prior peak except 2000.

This sounds like something similar you may have read recently, correct? Well, the date of this article was Sept 14, 2003. Just so you know, the market dipped about 2% shortly after the above was written and then never looked back rising 50% during the next 4 years. Yes, ultimately those gains were given up and more but a 50% rise in 4 years is not something to scoff at...further more, the above argument of the market being overvalued would suggest one go short the market which would have been disastrous. Which leads me to my point....what's the truth? What really counts when it comes to what moves the markets?

I've followed markets for 10 years now and I've been through 2 complete bear cycles and 1 complete bull cycle. These are the cycles you need to pay attention to and if you want to play them, you need to know what actually drives them...not what you think should drive them. By in large, I have found that the driving forces behind major market trends are 1) the expected trend in earnings (which is tied to the economy) and 2)investor psychology.


I see plenty of people making calls on the market based upon things like p/e ratios, debt to GDP levels, social security obligations, or other things have had ZERO predictive value. Most people I find try to impose their will on the markets claiming things such as "the market is overvalued and so it MUST come down".....there's too much debt in the system, the market is doomed".... "there's a social security time bomb ticking...the market is doomed". None of this stuff really matters unless these issues pose an immanent threat. These things might matter in the long, long term but the market doesn't look ahead 10-20 years, it looks ahead 6-12 months.

What the market tends to care about is not neccessarily the absoulte level of earnings but the direction of them. When earnings are in a rising trend, beating expecations most of the time you got yourself a bull market. When the opposite is true you got yourself a bear market. Pretty simple isn't it? OK I'm sure there's more to that than this but I gotta tell you, this is pretty much the meat & potatoes of what drives the market....at least that's how it's been for the past 20 years.


Investor psychology is just as important as the earnings trend. I’m talking about fear, greed, denial, and skepticism. Forget about p/e ratios and balance sheets...market participants are humans and humans are emotional. This is where the motto of this blog comes into play. Except for 911 type events, big drops/crashes in the market only happen when investors completely drop their guard. For example the 1987 crash didn't happen because the economy and earnings were about to tank, it happened because market participants got greedy sending the market to parabolic heights. The crash turned that greed into fear and the market began to recover almost immediately after it because the underlying fundamentals of the economy were still sound. In early 2002, despite the fact that earnings and the economy bottomed in late 2001 and were on the rise again, investors dropped their guard embracing that the worst was over until the Enron and WorldCom scandals resulted in a collapse of investor confidence triggering the final leg down to the bear market that started in 2000.

Earnings and investor psychology...these are the things that truly matter. You can whine and complain about the long term sustainability of earnings that are debt induced or driven by government spending or point out the structural problems the US has and what have you. Odds are, the market is not going to give a shit and will rise substantially if the economy and hence earnings are poised to expand for the next several months and years while expectations are modest. That’s the nature of the game. If you don't like the rules don't play the game.

Tomorrow morning I'll talk about the ST prospects of the markets.