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Craig Allen: Fiscal Cliff Hangover Not the Only Challenge We Face

The agreement Congress approved to avert the “fiscal cliff” — the expiration of the Bush-era tax cuts and spending cuts that resulted from the debt ceiling debate of 2011 — was more of a kick-the-can Band-Aid, rather than a true solution.

The resulting push of spending cuts for two months, and the looming debt-ceiling debate, set the stage for the real war of wills within Congress and with President Barack Obama. In the short term, however, fourth-quarter earnings look to challenge the financial markets far more than the threat of another impasse in Washington.

Alcoa will kick off the fourth-quarter earnings season Monday, and will likely set the tone for what could be one of the most impactful earnings seasons in recent memory. Although Alcoa is an aluminum company, and is therefore tied more to metals markets and specific demand factors for its products, many market watchers pay particular attention to Alcoa’s results as a kind of barometer for the overall market, and more specifically for the Dow Jones Industrial Average.

Alcoa is one of only five companies scheduled to report earnings this week. Wells Fargo will also report its results Friday, which should set the tone for the financial industry — the best performing sectors of the economy during 2012, gaining 26.3 percent for the year. A healthy financial sector is essential to a recovering economy. The Standard & Poor’s 500 overall returned about 15 percent for 2012.

The current recovery and associated bull market have been in effect for four years. Growth has been anemic, however, running at around 2 percent annually for the past two years. Most economists expect growth to continue at this pace throughout 2013, a rate of growth that is about two-thirds of the 3 percent we would normally expect to see during a recovery in the United States. Slower growth is directly reflected in corporate profits. Earnings have managed some decent performance over the past several quarters, although many companies have driven this good performance through cost cutting, including massive layoffs. As a result, unemployment remains elevated, at just below 8 percent.

The Federal Reserve released the minutes from its most recent meeting last week, revealing some disagreement among Federal Open Market Committee members regarding when stimulus should end. Several members indicated that they believe the enormous amount of bond purchases should end well before the end of 2013, conflicting with the widely held view of financial market participants that government intervention to drive interest rates down would continue indefinitely and at least until unemployment fell below 6.5 percent.

Holiday spending will also be under the magnifying glass, as we look to earnings — particularly from retailers — to see what impact the uncertainty surrounding the fiscal cliff negotiations had on holiday spending. From early indications for consumer spending throughout the holidays, it appears that spending was weak, which will certainly hurt the earnings of those companies that depend on strong seasonal sales for a large percentage of their annual earnings.

With the S&P 500 ending last week at its best level since 2007, at 1,466, it is clear that investors have largely ignored the threat of congressional gridlock, rising interest rates (if the Fed stops buying bonds), and weakening earnings. One possible explanation for last week’s strong rally is a positive reaction to the reduction of uncertainty, since Congress did — finally — agree to terms on the fiscal cliff, even if they did kick the can down the road two months on all spending cuts. Investors, relieved that Congress voted for something, anything, jumped back into stocks, driving the indexes to multiyear highs.

One interesting characteristic of the 2012 investing environment was that smaller investors, in large part, did not participate. This was especially true from the end of summer to the end of the year, again, primarily due to the uncertainty surrounding the fiscal cliff. The result was and is that there is a lot of cash in the hands of these smaller investors sitting on the sidelines. Some of this cash came flooding into the market last week, after the congressional vote. Historically, the small investor is usually wrong, is usually late to get in and late to get out. Certainly pushing the stock market to multiyear highs in the face of pending, possibly weaker than expected earnings reports and a massive fight concerning necessary and enormous spending cuts seems foolish.

Earnings estimates have been coming down from analysts across many industries, throughout the third and fourth quarters, so in a way, expectations have been tempered somewhat. Stocks are trading as if earnings and overall economic growth are expected to be robust, however. This is simply not going to be the case.

Earnings reports over the coming weeks, as well as the real fight over the fiscal cliff, could very likely drive stocks into a significant correction of 15 percent or more from current levels, or down to around the 1,250 range for the S&P 500. Investors should pursue a cautious stance here, and should look for trends in earnings to determine the true impact of the weakening economy, slower growth and pending (sizable) spending cuts on future earnings, and the overall impact all of this will likely have on stock prices going forward.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.

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