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.

First « 1 2 » Next