Beware the cliff.
Not that one, but the precipice that corporate earnings could be headed for regardless of what happens with current negotiations in Washington on taxes and spending.
The market appears fixated on every twist and turn in the fiscal cliff discussions, but investors may be ignoring a significant deterioration in corporate earnings that could get worse.
“We see three potential scenarios on the fiscal cliff: we go over it, we get a credible deal or they kick the can down the road again,” said Rick Scott, chief investment officer at L&S Advisors Inc., a registered investment adviser managing about $300 million in assets.
“It's a lose, lose, lose scenario if you focus on earnings,” he said. “With any of those outcomes, we think the earnings downtrend exhibited in the third quarter will get worse in the fourth quarter and into next year.”
Corporate profits already have been falling. More than two thirds of companies in the S&P 500 reported lower profits in the third quarter, versus the year-earlier quarter. On average, S&P 500 company earnings were down 1.6%, with 27% of companies beating consensus estimates and 54% missing them, according to research by L&S Advisors.
Mr. Scott said he thinks the profit picture is going to deteriorate further, no matter what happens in Washington.
Without a fiscal cliff deal, the business environment will get worse, and if deadlines are simply extended, the uncertainty for businesses will remain, he said. If a credible deal is reached, austerity measures will kick in.
Mr. Scott is positioning clients in defensive sectors such as pharmaceuticals, health care, food and consumer staples, and is ferreting out companies with positive-earnings momentum.
“It's a stock picker's environment,” he said.
He doesn't discount the possibility that a grand bargain between Democrats and Republicans could temporarily override investor concerns about earnings, but he prefers to play it safe.
“We might see a bounce in markets if we get a credible deal, but eventually, fundamentals will begin to become apparent,” he said. “Once the market discerns what's happening with earnings, stock prices will suffer.