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A Disappointing Earnings Season and the Fiscal Cliff

As we know, the stock market is often divorced from the economy as a whole. In other words, a bad economy does not always spell disaster for the stock market, but there is often a direct correlation.

This month I wanted to wait a little longer to send out our regular market commentary, so we could have a chance to see how the quarterly earnings season ended up. As expected, the results have not been encouraging.

Back in August, I wrote an article outlining the many economic concerns we are facing. The economy continues to face significant structural headwinds such as sluggish job growth, anemic GDP growth, potential fiscal issues related to the “Fiscal Cliff”, an exploding national debt, a European union that is on the verge of collapse, and slowing growth in China and other emerging markets (many Fortune 500 companies derive a large percentage of revenues from overseas).

As we know, the stock market is often divorced from the economy as a whole. In other words, a bad economy does not always spell disaster for the stock market. But it should come as no surprise that there is often a direct correlation.

Unemployment
Over the past few years, we have seen the stock market recover much of the losses it experienced in the 2008 bear market. Some of that recovery was a result of the market over-shooting to the downside in 2008/2009, with a natural upswing following. But something else happened. Big corporations started pumping out record profits in the following years.

How can that be? Unemployment was 8-10%, yet corporations were rolling in cash? Here’s where it gets tricky. For the most part, revenues (essentially GDP) were recovering modestly, while profits were exploding. OK, so simple math tells you that companies were cutting costs faster than revenues were growing. Being that we have become largely a service economy, which costs exactly were they cutting? Of course – labor

This is precisely why the stock market continued to rise despite persistent unemployment of at or above 8% for several years. Unfortunately, that cost cutting (job cutting) has come to an end, and this past quarter has proven that once you cut to the bone, you can only rely on revenue growth going forward. As fate would have it, now that we have massive unemployment (even with unemployment slowly dropping, there are fewer and fewer Americans actually participating in the workforce), we have lost the consumer demand for goods and services. Essentially, the economy is slowly grinding down again.

Up until very recently, the stock market had been resilient to these facts (I would use the term ignorant). Now that earnings season is coming to a close, however, investors are waking up to the fact that stock prices don’t exist in a bubble; on a long-term basis, one should only pay for a stock in direct proportion to its projected future profits.

Implications for Portfolios
As we have indicated the past six months, our client portfolios have already been positioned very conservatively. The prospective market risk/return ratio has continued to erode, and we are now at our most conservative stance in recent time. Last week, we further reduced exposure to the equity markets. At this point, we do not anticipate needing to make any additional changes. Should economic and market conditions improve, we will consider raising our risk exposure again. But at this point, we don’t anticipate that happening in the near future.

Robert Henderson is the President of Lansdowne Wealth Management, an independent, fee-only advisory firm in Mystic, CT. His firm specializes in financial planning and investment management for retirement, with a special focus on the particular needs of women that are divorced or widowed. He is an Accredited Asset Management Specialist and a Certified Divorce Financial Analyst. Mr. Henderson can be reached at 860-245-5078 or bhenderson@lwmwealth.com. You can also view his personal finance blog, The Retirement Workshop at http://lwmwealth.com/blog and the firm’s website athttp://www.lwmwealth.com

If you are an employee or retiree of General Dynamics, Pfizer, or L&M Hospital, and you would like advice and direction on managing your Fidelity 401K or Hewitt 401K plan, please sign up for our monthly newsletter, which provides complimentary ongoing advice, commentary, and model portfolios for each of those plans. You can sign up automatically athttp://www.lwmwealth.com/services/your401k.html.

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