My Comments: It seems the DOW hits a new record every week and everyone is wondering when the penny is going to drop and once again, we fall into the abyss. Most of us think it will happen, but not anytime soon. Here’s another analysis worth reading.

By Jeffrey Dow Jones

This week (April 8) 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. Here 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.

This table does something really cool. It isolates the degree to which each of these moves was driven by change in sentiment. The rallies at the top of the table were driven more by fundamentals. The ones at the bottom were driven more by multiple expansion.

Of the greatest, continual bull markets in history, you can see that the one we’re currently in is largely due to improving sentiment. In other words, earnings have improved in recent years, just not a lot relative to historical earnings. You can see now why today’s environment is such a marvelous puzzle for market historians.

That’s all handy to know. But what you really care about is the column on the far right, the one called “subsequent bear market loss.” When you look at it, you’ll notice a disturbing trend: the more the market was driven by sentiment, the bigger to subsequent correction was.

There aren’t a ton of data points on here, but the basic idea underpinning this whole study is solid. Markets can only get so cheap before smart investors step in and say, “OK, enough is enough, y’all are crazy.” When a large portion of the rally is fueled by legitimate economic growth, stock prices have a much bigger cushion under them than when the rally is driven by sentiment.

This brings us to the next image you need to sear into your temporal lobe.