As Expectations for 3Q Earnings Season Fall, What’s the Best Investment Strategy?

Expectations for 3Q Earnings Season Fall, What’s the Best Investment StrategyInvestment risk for the very near-term stock market is going up. There’s been pressure on interest rates, investor sentiment was hit by the lack of tapering to quantitative easing, and finally, the third-quarter earnings outlook is mediocre at best.

Everything related to the stock market has been exceptional this year. While earnings growth was completely and totally lackluster, with several exceptions, the main stock market indices proceeded to rise tremendously based on continued monetary expansion and the fact that there really is nowhere else for investors to go but stocks.

Second-quarter earnings season was unimpressive, and I think it will be the same for the third-quarter reporting season. Financial results very well could be the catalyst for a major market retrenchment in October. I think that all investors need to prepare for such an eventuality. Generally speaking I do think that stocks can continue to rise in 2014; however, corporations will have to provide genuine earnings growth and top-line growth to keep valuations from pushing the envelope.

I would say that, given current earnings and expectations for 2014, the stock market is at least slightly—if not fully—overvalued at present. With the expectation of very modest earnings growth in the third quarter and little in the way of sales growth (especially among large-cap companies), recent stock market strength has been an expansion of valuations only.

This is why I’m so cautious near-term and why October could be a wild ride for share prices.

It is quite likely that market leaders that did well in the first two quarters of this year will continue to do so. These are the “Johnson & Johnsons” of the equity market universe—these are the companies that have been well bid by institutional investors. (See “Consistency, Rising Dividends Make This Benchmark A Possible Winner for Savers.”)

The health of large corporations continues to be robust. But if their earnings can’t outperform or sales growth is nonexistent, then the last carrot attracting shareholders is increased dividends.

I think we’re going to get a lot of news related to new share buyback programs and increasing dividends for the simple reason that companies won’t be able to beat consensus earnings in the third quarter.

Or at best, they will produce results similar to the second quarter, when most corporations were not able to beat consensus on both revenues and adjusted earnings.

These are the makings of the next recession in 2014. Rising interest rates, continued lackluster revenue and earnings growth from companies, and mediocrity in other mature economies can certainly tip the GDP scale.

I am therefore very cautious on the near-term outlook for stocks, and I do believe that the marketplace will continue to stick with its existing winners. These are the companies that can deliver on revenue and earnings expectations with rising dividends. It’s a blue-chip market, and in a slow-growth environment, the big brand-name companies are what you want to stick with.