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How to Prepare for a Spring Swoon in Stocks

Suzanne McGee, Fiscal Times
Monday, 8 Apr 2013 | 12:48 PM ET
Christan Baitg | E+ | Getty Images

This week marks the official start of the first quarter earnings season, a six-week period during which publicly traded companies will try to impress investors with their ability to generate profits in spite of an economy that – outside the housing sector – remains lackluster. The bigger question, however, is whether those results will be robust enough to offset the prospect of a springtime swoon in stock prices.‬

Let's forget about historic seasonal patterns. So what if April has proved to be a dismal month for stock investors in each of the last three years, marking the starting point of a selloff that lasted for months and produced declines of anywhere from 9 percent to 17 percent? Markets just aren't that deterministic, plunging when the calendar says that a new month and a new quarter have begun; they need some kind of catalyst to cause investors to experience a degree of fear. In 2010, that proved to be the beginning of the European sovereign debt crisis; two years ago, the U.S. lost its triple-A credit rating. Last year's slump – the most muted of the three – can be traced back to economic worries.‬

Certainly, as Friday's employment data showed, there are reasons to worry about what is happening to the broad economy. The housing industry may be in recovery, dragging companies ranging from paint manufacturers to timber producers along with it. But if the economy is growing, it isn't doing it at a fast enough pace for companies to feel comfortable adding to their payrolls. That in turn may be signal that consumer confidence is wobbly, which may produce a downturn or at least more sluggish growth in retail sales. Ultimately, that is bound to filter back to corporate profits – and pricing in future growth in earnings is what the stock market is all about, after all.‬

Fourth-quarter profits were far more robust than most analysts had expected – even if the absolute gains weren't all that large – and a string of positive surprises reported throughout January and February kept the stock market rally chugging along. Now investors hoping to hang on to the their gains are praying that the bearish tone of many forward-looking earnings forecasts by both companies themselves as well as the analysts who cover them proves to be just a way of setting up a some more positive earnings surprises this spring.

To the extent that this happens, and that those earnings announcements aren't accompanied by cuts to forward-looking estimates for the summer and fall, then April 2013 could break the recent pattern.‬ But at some point, the market is going to stop rallying at the pace it has demonstrated so far this year. Even if profit growth for the S&P 500 turns out to be in the vicinity of 3 percent or 4 percent in the first quarter, well above the average of many top-down analysts who specialize in tracking corporate earnings, we're not likely to witness 10 percent quarterly gains in the S&P 500 for the entire year. Rationally speaking, there simply aren't enough positive catalysts out there for that to happen. Stocks, as a group, are not going to end the year 35 percent higher.‬

More From The Fiscal Times: 7 Hot Tech Stocks to Watch in 2013

The question today is what might cause the market to stall or slump; how long that might last and how large a decline might be produced as a result, and what would cause it to rebound once more. The answer to the first question is actually more straightforward than you might think: confidence. Every additional percentage point of return from the stock market translates into the collective blood pressure of investors climbing just a little bit higher.

At the same time, the flow of macroeconomic news is deteriorating, albeit not dramatically, with one piece of good or acceptable economic data followed by another that is slightly worse than anticipated or even downright bearish. After months of stock market gains, at some point those nervous investors will start reacting differently to that data: They'll worry more about the negative data points and draw less encouragement from the more robust signals.‬

Then there is the potential for a sharp, sudden shock to derail confidence. So far, the market has withstood the Cyprus crisis and sequestration; both the European economic debacle and our own fiscal problems in the United States have the potential to worsen significantly this spring. If that happens, the best earnings reports in the world won't be enough to cushion the blow: Those earnings capture what has happened, while the market prices of stocks places greater weight on what investors collectively believe will happen in the future.‬

At some point, the blow will fall. Perhaps it will be in spring; perhaps not until summer. Perhaps it will arrive in the form of a sharp selloff; perhaps it will simply be that the market flatlines, going nowhere for months at a time. The question isn't whether this will occur but rather how you will react when that happens.‬

Are you comfortable with your portfolio? If the first-quarter rally, along with the gains in the final weeks of 2012, has left your asset allocation out of whack, this might be a good time to ponder whether you are comfortable‬ with having a heavier allocation to stocks than you did last autumn.

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If there is a selloff, will you want to use that as a buying opportunity? In other words, do you believe that stocks still offer more upside potential over the long haul than do bonds? If so, you might want to prepare by taking some profits off the table now and parking them in cash.

Do you believe that a stock market decline will mark just a hiccup in the relative performance of various asset classes, or the beginning of some kind of new secular trend? What do you think about the Federal Reserve's continued willingness to keep interest rates at rock-bottom levels – and do you fear that it is producing a kind of bond market bubble?‬

The more able you are to reflect on how you would answer some of these questions, the better prepared you are for whatever market swoon takes place, whenever it occurs.

Will it happen? Certainly. As the old market saying puts it, trees don't grow to the skies. A selloff may well not take place in April, or even this spring – we could be in for a batch of blockbuster earnings and even an expansion in the price/earnings multiple that would follow investors' being willing to pay more for each dollar of corporate profits – but it will take place, as inevitable as death and taxes. You can't control when that happens or what proves to be the catalyst, but you can anticipate how you will react. And in that case, planning is always better than blind panic.‬

This week marks the official start of the first quarter earnings season, a six-week period during which publicly traded companies will try to impress investors with their ability to generate profits in spite of an economy that – outside the housing sector – remains lackluster. The bigger question, however, is whether those results will be robust enough to offset the prospect of a springtime swoon in stock prices.‬

Let's forget about historic seasonal patterns. So what if April has proved to be a dismal month for stock investors in each of the last three years, marking the starting point of a selloff that lasted for months and produced declines of anywhere from 9 percent to 17 percent? Markets just aren't that deterministic, plunging when the calendar says that a new month and a new quarter has begun; they need some kind of catalyst to cause investors to experience a degree of fear. In 2010, that proved to be the beginning of the European sovereign debt crisis; two years ago, the U.S. lost its triple-A credit rating. Last year's slump – the most muted of the three – can be traced back to economic worries.‬

Certainly, as Friday's employment data showed, there are reasons to worry about what is happening to the broad economy. The housing industry may be in recovery, dragging companies ranging from paint manufacturers to timber producers along with it. But if the economy is growing, it isn't doing it at a fast enough pace for companies to feel comfortable adding to their payrolls. That in turn may be signal that consumer confidence is wobbly, which may produce a downturn or at least more sluggish growth in retail sales. Ultimately, that is bound to filter back to corporate profits – and pricing in future growth in earnings is what the stock market is all about, after all.‬

Fourth-quarter profits were far more robust than most analysts had expected – even if the absolute gains weren't all that large – and a string of positive surprises reported throughout January and February kept the stock market rally chugging along. Now investors hoping to hang on to the their gains are praying that the bearish tone of many forward-looking earnings forecasts by both companies themselves as well as the analysts who cover them proves to be just a way of setting up a some more positive earnings surprises this spring.

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Earnings Season Outlook
Warning signs and other signs analysts are watching ahead of this earnings season, with CNBC's Seema Mody.

To the extent that this happens, and that those earnings announcements aren't accompanied by cuts to forward-looking estimates for the summer and fall, then April 2013 could break the recent pattern.‬ But at some point, the market is going to stop rallying at the pace it has demonstrated so far this year. Even if profit growth for the S&P 500 turns out to be in the vicinity of 3 percent or 4 percent in the first quarter, well above the average of many top-down analysts who specialize in tracking corporate earnings, we're not likely to witness 10 percent quarterly gains in the S&P 500 for the entire year. Rationally speaking, there simply aren't enough positive catalysts out there for that to happen. Stocks, as a group, are not going to end the year 35 percent higher.‬

The question today is what might cause the market to stall or slump; how long that might last and how large a decline might be produced as a result, and what would cause it to rebound once more. The answer to the first question is actually more straightforward than you might think: confidence. Every additional percentage point of return from the stock market translates into the collective blood pressure of investors climbing just a little bit higher.

At the same time, the flow of macroeconomic news is deteriorating, albeit not dramatically, with one piece of good or acceptable economic data followed by another that is slightly worse than anticipated or even downright bearish. After months of stock market gains, at some point those nervous investors will start reacting differently to that data: They'll worry more about the negative data points and draw less encouragement from the more robust signals.‬

Then there is the potential for a sharp, sudden shock to derail confidence. So far, the market has withstood the Cyprus crisis and sequestration; both the European economic debacle and our own fiscal problems in the United States have the potential to worsen significantly this spring. If that happens, the best earnings reports in the world won't be enough to cushion the blow: Those earnings capture what has happened, while the market prices of stocks places greater weight on what investors collectively believe will happen in the future.‬

At some point, the blow will fall. Perhaps it will be in spring; perhaps not until summer. Perhaps it will arrive in the form of a sharp selloff; perhaps it will simply be that the market flatlines, going nowhere for months at a time. The question isn't whether this will occur but rather how you will react when that happens.‬

Are you comfortable with your portfolio? If the first-quarter rally, along with the gains in the final weeks of 2012, has left your asset allocation out of whack, this might be a good time to ponder whether you are comfortable‬ with having a heavier allocation to stocks than you did last autumn.

If there is a selloff, will you want to use that as a buying opportunity? In other words, do you believe that stocks still offer more upside potential over the long haul than do bonds? If so, you might want to prepare by taking some profits off the table now and parking them in cash.

Do you believe that a stock market decline will mark just a hiccup in the relative performance of various asset classes, or the beginning of some kind of new secular trend? What do you think about the Federal Reserve's continued willingness to keep interest rates at rock-bottom levels – and do you fear that it is producing a kind of bond market bubble?‬

The more able you are to reflect on how you would answer some of these questions, the better prepared you are for whatever market swoon takes place, whenever it occurs.

Will it happen? Certainly. As the old market saying puts it, trees don't grow to the skies. A selloff may well not take place in April, or even this spring – we could be in for a batch of blockbuster earnings and even an expansion in the price/earnings multiple that would follow investors' being willing to pay more for each dollar of corporate profits – but it will take place, as inevitable as death and taxes. You can't control when that happens or what proves to be the catalyst, but you can anticipate how you will react. And in that case, planning is always better than blind panic.‬

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