Earnings Surprises and the Fiscal Cliff

This article was originally published by Zacks.com.

Believe it or not, there is good that can come of the U.S. partially going over the fiscal cliff; if you know what to look for and have the right strategy.

In theory, the U.S. actually went "over" the fiscal cliff, since the midnight Jan. 1 deadline was not met. Lawmakers did clear the way for tax hikes on Americans making $400,000 or higher and raised the estate tax on large inheritances. But the details on the budget still have yet to be worked out and lawmakers agreed to extend the timeline on spending cuts by roughly two months, in which time the U.S. would face a potential default on their debt.

This semi-solution leaves investors cautious, but still hopeful. The reality is that aside from rising health care costs, most of the middle class will not see a major tax increase and should able to manage their expenses and continue to grow the U.S. economy in 2013 ... albeit slowly. This is part of the reason the markets rallied on Jan. 2.

How can this be good?

There are 14 stages of investor sentiment; these variations can be fairly easy to spot at times and illusive at others. Stocks often trend depending upon the psyche of investors, not always on hard fundamental data.

Interestingly enough, there is clarity amidst the chaos. As we enter into the New Year, there is no doubt that markets are somewhat cautious, as is the average American.

While I feel we are far from panic, despondency or depression, I think that there is a sense of "hope" in the marketplace, which actually puts us fairly close to the point of maximum profitability in the market's emotional cycle (see the chart below).

Before last earnings season began, I believe that markets were overly excited and closer to the "thrill" area of the psychological curve. In fact, if you look at a daily chart of the S&P 500 over the past three months, you can see these emotions play out in stock prices.

In mid-September, markets were completely euphoric running up into the elections, with the fiscal cliff just a twinkle in the eye of only the savviest investors. After the election results and woes about the cliff and future of the economy, the market quickly gave back 9%, changing the mood from elation to outright depression.

This reality check that was dealt by the cliff unknowns and cautious tone of analysts set the stage for us to profit as markets are now in a more realistic mood, expecting mediocrity at best.

My theory is further proven by the extremely positive reaction to a less than perfect solution; if markets were completely euphoric and overbought, I don't believe we would have seen such a bullish move.

While emotions can rule the markets much of the time, the

objective

subjective

overtakes

four times a year when stocks report their results (earnings). If the subjective mood is not "overly euphoric" then stable objective data should cause stocks to rise; this works in the opposite direction as well of course.

A very smart man once told me that the brightest opportunities usually lie in the darkest of places. Sometimes when it feels like the worst time to be investing, that might be the best time to dip your toe in.

Resiliency in earnings

I'd be lying to you if I said that corporate revenues are shooting up and that the average company is making money hand over fist. But I can say that there are three things that I feel very good about coming into 2013:

Corporations are lean and mean

1.

The average American company has cut costs and economized their businesses to keep margins high and operate in a low growth environment.

Hoards of cash

2.

We are seeing many companies stockpiling cash and equivalents, preparing themselves not just for the worst, but for the turn. The turn being an improvement in the economy and that cash is utilized for expansion, M&A, share buybacks and dividends.

Expectations low

3.

As I mentioned last quarter, expectations were relatively low; but more recently the average share price and growth estimates have come down even further. This makes the reaction to a positive surprise that much more significant. Even though Q4 earnings won't be the strongest we have seen in years, stability and moderate growth should be enough, in the right stocks, to propel them higher. Keep in mind that average GDP growth estimates for 2013 are at 2% or less, which is very realistic.

These factors will help support the markets throughout the year and, with a little luck and continued stability overseas, the markets should hold their ground by the end of 2013.

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