One of the few constants in realm of investing is that most of the variables – interest rates, commodity prices, and profit margins – move in cycles and not straight rising/ falling lines. In addition to demand and supply dynamics, human emotions especially greed and fear play a contributing role in creation, sustenance and reversal of cycles. When things go well, greed fuels the rise of a cycle and when things do not go well, fear exacerbates the fall.
A corollary to existence of cycles is the tendency of these variables to revert to mean. Of specific interest to us is the position of earnings and multiples assigned to the earnings in that cycle. Not only profits revert to mean, the multiples that market is willing to pay for the earnings also revert to mean. In a downwards earnings curve, markets – dictated by emotions- often assume that bad times will continue and assign lower multiple resulting in double down effect on prices. And, vice versa in good times. If our belief is that earnings will revert to mean, we can be reasonably sure that multiples too will revert to mean.