Could The Earnings Cliff Overshadow The Fiscal Cliff?

Investors looking out for the fabled fiscal cliff should be careful not to tumble down the “earnings cliff,” if corporate profits plunge.

“When we look at the data from the third quarter of this year, we’re not seeing a rosy picture,” said Rick Scott, chief investment officer and senior managing director at L&S Advisors, an RIA in Los Angeles. “In every fiscal cliff scenario, there is a potential for weak earnings in the next one to three quarters.”

According to Scott, sales growth for S&P 500 companies was a “measly” 1.2% in the third quarter. The number of companies that lagged expectations was twice the number of upside surprises.

“In terms of earnings per share,” he said, “25% of S&P 500 companies did worse than expected. By comparison, the trailing five-year average was only 19% of those companies.” Thus, earnings are starting to deteriorate in a fragile economy–and earnings are the key to stock market performance.

Fiscal cliff outcomes bode ill for earnings next year.

“If we go over the cliff,” Scott said, “severe tax increases and spending cuts could shock the economy into a recession. Job losses and income losses could provide a rude awakening for consumers, leading to reduced spending. Businesses may be less willing to spend, too.”

Other scenarios include a resolution of government fiscal issues and “kicking the can” into the future, Scott said. A resolution that isn’t credible will merely turn today’s short-term problems into long-term problems. “Even a credible resolution will be disruptive,” he said, “if the plan calls for lowering the deficit by increasing revenues and cutting expenditures.”

In such an environment, advisors need to pay attention and proceed carefully. Scott said investors might do well to avoid industrial, materials, and energy companies, which could lose ground in a recession.

“Some pharmaceutical companies could get hurt,” he said, “if changes to Medicare result in lower payments for drugs. A possible reduction in the mortgage interest tax deduction could have an effect on housing; defense stocks also could be losers.”

On the positive side, Scott is upbeat about consumer staples, biotech, certain pharmaceuticals with strong pipelines, and some popular tech companies.

“Advisors who do their homework and keep up with the news,” he said, “are likely to do better than those who buy and hold.”