Despite recent market performance following the so-called “fiscal cliff” scenario last year, investors still have another precipice on the horizon to worry about -- an earnings cliff. The possibility of a drop-off in corporate earnings looms ahead as companies have yet to feel the full economic impact of the unresolved budgetary and revenue concerns left on the table by the federal government following the passage of the American Taxpayer Relief Act in January.

If the can gets kicked further down the road within the current budget talks, the earnings cliff may appear less imminent. However, once the executive and legislative branches of our government develop a credible package to address budgetary issues, including significant spending cuts and tax increases, corporate earnings are likely to take a hit.

As the story unfolds in the coming weeks and months, investors are wise to take an active, risk management approach to reduce exposure to a potential earnings cliff. Recommended investment strategies to navigate such market challenges will be explored further in this article, including the importance of monitoring risk, not the market; considering cash as an asset class; conducting due diligence to find growth opportunities; and the value of meaningful diversification.

Fragile Economy Heightens Earnings Cliff Risk

Corporate earnings, which are the “mother’s milk” of the equity markets in the long run for investors, remain highly vulnerable to the outcome of federal spending and revenue issues left unresolved at the end of last year. While the Q4 2012 earnings picture appeared to be relatively stable, potential risk to future earnings lurks under the surface with possible sequestration cuts and/or other difficult decisions intended to resolve the budget crisis and debt issues that will affect consumer and corporate spending.

The possibility of an earnings cliff is all the more troubling for investors given the fragile economy. For 2013, the Congressional Budget Office (CBO) is predicting a meager 1.5 percent in GDP growth for the year. Companies and their consumers remain particularly vulnerable to this economic outlook if it becomes reality.

Many companies are just beginning to stick their heads above the water to assess future plans for spending and expansion, but if more trouble appears on the horizon, they are likely to retreat to a more conservative approach with decreased hiring and growth. As consumers are negatively impacted by these developments, we could see a snowball effect of depressed consumer spending and lower corporate earnings.

Declining productivity also poses a potential threat to profit margins, with a 2 percent decrease in productivity reported in Q4 2012. At the same time, raw material costs and wages are on the rise. Prices for crude oil, agricultural goods, chemical products and metals such as platinum have gone up. As a result, companies are feeling the pinch of higher costs with less output.

Already, many companies are feeling dismal about the future. During the Q4 reporting period in January, 56 companies, more than 10 percent of the S&P 500, issued earnings guidance to prognosticate on their performance. Eighty percent of these companies (45 out of 56) issued a negative forecast, with only 11 companies issuing a positive forecast.

Given the outlook of the precarious state of the economy, it seems that it’s not going to take much to push us over an earnings cliff. Earnings may be poised to come under serious pressure in the coming months, leading to increased risk and concerns for investors.

Strategies To Avert An Earnings Cliff

As investors keep an eye on the future possibility of an earnings cliff, they can position themselves to take an active, risk management approach to help minimize the risks of going “over the edge.” The following are a few principles they can follow to keep client portfolios on a safer path.

  • Monitor Risk, Not the Market: For investors, what matters most is watching the economic landscape, not just what the stock market is doing. This starts with a macroeconomic analysis of the forces, themes and risks that define and inform global capital markets. Through this process, one should monitor risk factors, including national production, personal income, employment, interest rates, political instability, monetary trends, commodity prices, housing, stock market volatility and consumer confidence, to name a few. Based on this analysis, investors can better understand and anticipate the movements of stock and commodity prices, interest rates and business cycles.
  • Do Your Homework: Due diligence doesn’t stop once investors have identified targeted sectors and industries as potential investment opportunities. From there, they need to vet out the most compelling security selections based on an individual company’s balance sheet, earnings growth, yield, valuation (price to earnings, price to book value, price to sales), management expertise, and franchise value in selecting securities within targeted industries.
  • Consider Cash As An Asset Class: The prudent use of tactical cash as an asset class holds potential to smooth out return patterns, providing protection from capital loss and meaningful participation in equity market advances at the start of directional change. In fact, cash positions within a “long-cash” strategy can significantly reduce the risk of loss of investment capital during market downturns.
  • The Value Of Meaningful Diversification: Investors can take a meaningful approach to diversification by incorporating the principles described above into their investment planning. With precise attention to risks, investors can seek growth and income opportunities across a variety of targeted industries and asset classes, including the relative safety of cash when risk indicators signal an elevated potential for loss.

As current budget negotiations move forward, investors may not be able to breathe a sigh of relief for the foreseeable future. However, by following sound investment principles, they can stay the course to avoid loss and maximize a risk-adjusted return even within a questionable earnings environment.

About the Author:

A former SEC attorney and chief investment officer at L&S Advisors, Rick Scott brings more than 30 years of expertise in portfolio management to his firm L&S Advisors, which he co-founded with CEO Sy Lippman. As a fiduciary for high-net worth clientele, L&S Advisors employs a tactical, active investment strategy that is guided by the firm’s proprietary risk management methodology and philosophy. L&S Advisors is an independent, fee-only registered investment advisor (RIA) dedicated to managing assets for high-net-worth individuals and families as well as institutional accounts, endowments and family offices.