With the stock market moving back up to all-time highs, I’ve been taking a breath and reflecting on the market. We are in the thick of earnings season. While many stocks are beating Wall Street’s earnings expectations, the same companies are seeing their actual earnings drop from their prior quarter’s levels.
It is interesting to note how much focus is being placed on relative earnings versus absolute earnings. For example, a company’s net income may be lower than the comparable period, but the current period’s net income is higher than analyst projections for the current period. Where actual numbers are beating expected numbers, I’m seeing price earnings ratios (P/E) expansion. Therefore, investors are more willing to pay a higher amount per dollar earned for the better of the companies who are making less money than the prior quarter.
P/E expansion tells me that more investors are paying up for the companies that are doing "relatively better". Professional managers are chasing those companies in order to stay ahead of the indexes to which their performance is incessantly compared to. Individual investors are not subject to the same index pressures, but they suffer from their behavioral biases to keep “up with the Jones”.
So earnings are generally decreasing while P/E’s are expanding. This type of environment encourages investors to take on more risk by buying at market levels that are “relatively high”.
I find it advantageous at this point to revisit companies’ fundamental metrics and refine investment models. I’ve also been revisiting historical purchases. What I’ve found is that my best purchases decisions were made when earnings were at a low point and rising, and P/E’s were also at a relatively low point.
My musings have brought me to the point that I find it is a good time to exercise caution. By focusing on investment models and historical evaluations, it helps to keep my focus on activities other than making purchases that appear relatively high.
I might not be getting the new car that the “Jones” are getting, but I’m getting piece of mind that I’m not owning a seven year car loan!
