As we get into the heart of earnings season, investors will be watching the quarterly results in order to predict the market’s reaction, both short- and long-term. Earnings reports help us gauge the health of individual companies, as well as the broader macroeconomic trends across industry sectors. At the same time, it is important to note that stock price action will often move seemingly at odds with earnings results. This because, at least in the short term, markets do not trade on valuation alone. Moreover, valuation itself is a tricky game.

Henry Blodget explained some of the difficulties inherent to valuation in a 2004 article:

A share of stock is, in theory, worth the “present value of future cash flows” attributable to the share. (In practice, a share is worth what someone will pay for it, but leave that aside for a moment.) Given the confidence with which some commentators cite the theory, a casual observer might assume that the “present value of future cash flows” is an indisputable number, akin to a price tag on a can of soup. In reality, however, it is not a number but an argument, and, in most cases, it is a surprisingly imprecise argument, with a wide range of reasonable conclusions.

Blodget goes on to discuss the complexity of evaluating future cash flow given the uncertainties of the broader economic environment, future earnings, and, particularly, interest rates. As he says,”Over the long haul, thankfully, valuation does matter: The market is not random, stock prices do tend to regress to long-term means, and long-term investors are better off buying when stocks are cheap. As discussed in a previous piece, however, the “long term” is long (decades, not years), and valuation is not a particularly helpful prediction tool over timeframes of three months to a couple of years (not worthless—just not particularly helpful).”

In this light, we can consider the prior two quarters of earnings results, post meltdown, that led to continuation of our remarkable rally. At no time since the financial crisis began have company earnings been particularly good. In fact, across the board, both revenue and earnings have been down drastically. Remaining profits often have been the result of cost-cutting, or in the case of the larger banks, profits from trading with taxpayer dollars. Moreover, when it comes to banks and REITs, financial results have not been marked-to-market. Therefore there are certainly enormous unreported liabilities throughout the system. As in many billions of dollars worth. The media has generally reported the sustained rally as being due to improving economic conditions. Perhaps to a degree this is the case. At the same time, it is equally likely that we have rallied due to the massive liquidity injected through bailouts, quantitative easing, and other government activities. Disaster was averted. Yet it is unclear that anything has truly been fixed. On the contrary, we have seen a massive wealth transfer from US taxpayers to Wall Street, in a desperate attempt to solve an overleveraging problem by simply taking on more debt. Our “jobless recovery” rests on very shaky foundations indeed. Most likely it simply sits atop a newly-formed asset bubble.

This week Doug Kass wrote up an excellent analysis of the current season’s earnings, drawing the following conclusions:

1. The third-quarter beats were overhyped as they are the outgrowth from lowered guidance.

2. If one divides the third-quarter earnings reports by end-market categories, differentiating between the beneficiaries of restocking and those companies that are closer to the end markets and consumption, it leads to two different pictures as to the health of corporate earnings.

3. If end demand doesn’t pick up (and pick up quickly), the 2010 earnings outlook for many industries (such as semiconductors and other beneficiaries of restocking) will be in jeopardy, as will be the now ambitious consensus for S&P 500 earnings of over $70 a share next year.

So what is an investor, or trader, to do in such an environment? For now, the market continues to go up. I remain very cautiously net long in my portfolio, with an emphasis on stocks in the following sectors: energy (especially clean energy), Brazil, China, and select technology stocks. In my view the pickings are getting slimmer, and other signs indicate we may be nearing the a market top. Investors should note in particular the inverse directional relationship between stock market and the dollar. Talk is increasing in Forex circles that the dollar is due for a trend change. Moreover, other countries may soon follow Brazil’s lead in making policy changes to prevent overvaluation of their currency with respect to the dollar. The world does not want an overly weak dollar. With countries vying to devalue their currencies, and with an appreciating dollar, risk appetite is likely to abate, and stock markets globally could lose momentum quickly.

In other words, if you are a trader, the trend is still up, for now. If you are a long-term investor, tread with caution, whatever the earnings reports may say to you.

I’ll end with one recommendation. Apple (AAPL) reported earnings this week, and broke to new highs on very heavy volume. This company is a superstar. If you are investing for the short- or long-term, you can’t go wrong here.