Investors should be aware that in an up cycle, analysts would do two things:
1. to upgrade the earning forecast almost on a regular basis, and,
2. to accord the stock on a higher valuation (i.e. stock is now valued at a higher PE ratio).
This, we call, earning expansion and PE ratio expansion.
Normally, the analysts would do this a couple of times during a complete up cycle.
In a down cycle, the reverse happens. That is, earning and PE ratio (valuation) contract.
For those who have been investing over the last 4 years, they would have observed these in the analysts reports during the bull and the bear phases of the market.
What lessons should we learn from this?
We should not be sucked into this as we know that a very high EPS forecast is not sustainable (as compared to its historical records), and hence disappointment or downgrade would ahve to occur and we need to get out of this before it happens.
Thus, it is very important to know the big picture to gain an inkling of which stage of the economic cycle we are in now and how it is going to move looking forward.
Hence, when we look at EPS growth, we should ask ourselves whether it is sustainable in the next few years.
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