The Wall Street Waltz: 90 Visual Perspectives, Illustrated Lessons From Financial Cycles and Trends, Revised and Updated Edition

Chart 3

Earning a Good Return in the Market

“Well, if earnings can be misleading, why does everyone focus on them so much and, particularly, why do you do so in this book?” (See Charts 1, 4, 17, 28 and 43.) Earnings are often misleading in the short term But in the long term, as this chart depicts, earnings control the market's direction. This chart shows a 44-year span where the Standard & Poor's (S&P) index of 425 industrial stocks is stacked up against the earnings of the underlying companies. Between 1945 and 1958, there is a wide discrepancy between the two lines, as earnings were high relative to stock prices. But for most of this chart's time span, the long-term fit between earnings and stock prices is compelling.

Earnings and stock prices are tightly correlated in the long term because of one of the aspects of stock ownership that you get with virtually no other form of investment. As a stockowner, you are a part owner in a business—a nonbiological, but almost living, entity with the capacity to adapt and prosper as economic conditions change. Let's say costs rise for car markers. If people want to buy cars, they will have to pay higher prices. The car maker can respond through better marketing to convince customers why they should want cars at higher prices, or respond through cost-reduction efforts to get back to square 1, or diversify into new areas where costs may be low. The possibilities are limited merely by the limits of management's combined creative imagination. ...