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There are no guarantees in life except death, taxes, and the Chicago Cubs not winning the World Series again. One thing stock market history has taught us, however, is that it pays (or at least saves) to be prepared for the element of negative surprise.

There is a lot that could go wrong right now and those potential risks get mentioned often. Because that is the case, it is often said that those risks are priced into the market because they are known risks. One shouldn't take that view for granted.

With the S&P 500 sitting near multi-year highs and the P/E multiple expanding as earnings growth decelerates, it seems the only thing priced into the market are positive outcomes for all known risks. That will prove costly if the future gets clouded by an unforeseen development or the known risks take an unexpected turn.

Earnings Risk

For some time now, we have been discussing the deteriorating economic conditions around the globe, highlighting the spillover effect to corporate earnings.

In brief, weak levels of aggregate demand will lead to weak revenue growth which will lead to weak earnings unless companies find a way to expand profit margins that are already near record high levels. That is a tall order and we are not optimistic at this juncture that it can be filled.

That challenge is reflected in the fact that third quarter earnings are expected to decline 2.0% on revenue growth of just 0.1%, according to the latest data from Thomson Reuters.

Fourth quarter earnings, meanwhile, are still projected to increase 10% with the U.S. economy barely growing 1.0%, many eurozone economies in recession or trending in that direction, and China clearly slowing down. That is down from a projection of 14% growth as recently as July 1, yet there still seems to be a lot of hope tied up in that estimate.

We expect the fourth quarter earnings growth estimate to come down as the third quarter reporting period unfolds.

The market, however, doesn't appear to be too concerned with the increased likelihood of downward earnings revisions.

Heck, the negative-to-positive preannouncement ratio for the third quarter is 4.3. That is the weakest, Thomson Reuters says, since the third quarter of 2001.

click to enlarge images

Negative guidance be damned. The S&P 500 rose a whopping 5.8% in the third quarter due in part to a confident feeling that any earnings weakness will be transitory.

No Fight in the Market

The equity market's strength in the third quarter really rested on the biceps of Ben Bernanke and Mario Draghi who did some heavy lifting with their open-ended, if somewhat conditional, pledges of monetary policy support.

The market's interpretation, it seems, is that liquidity trumps risk. That perspective is captured in the long-held market axiom: "Don't fight the Fed." It is also seen in the following chart, which shows the divergence between the forward four quarter consensus earnings estimate and the S&P 500 during the third quarter.

Our concern is that the Fed's jabs are becoming less effective with each round of easing. A lot of bullish expectations are resting on the Fed's ability to maintain its status as heavyweight champion of the world. What happens, though, if the real economy counter punches and knocks the Fed out as a credible fighter?

There is a genuine risk that the Fed's policy will not work in its intended fashion. If the market loses faith in the Fed before the real economy turns up, the stock market could face a quantitative easing of a different kind (i.e. a material pullback).

That outcome, however, is not in the market. What is in the market, as evidenced by the 14% rally since June 1, is that QE3 will only produce a positive outcome.

We suspect the equity market will continue to cling to Fed policy in the near term as a support structure, but the risk is building the longer the Fed stays involved in its unconventional manner. That risk could be inflation, but that will probably not be the case for some time given the excess labor capacity.

No, the real risk lies in the equity market losing faith in the Fed, and other central banks, as market saviors. A deteriorating earnings picture is turning that into a real risk that should not go unappreciated when choosing not to fight the Fed.

From Cliff to Compromise

Another known risk, which is increasing in prominence by the day, is the fiscal cliff. It is possible that capital gains and dividend taxes will increase effective January 1 -- and perhaps by a lot for upper-income earners. That prospect is certainly not in a market that hit its highest level since 2008 as recently as September 14.

Higher capital gains and dividend taxes are only a few of the loose boulders resting on the fiscal cliff. Mandated spending cutbacks and a bevy of other potential tax hikes are also loosely resting there. We took a closer look at the fiscal cliff issue in our August 27, 2012, Big Picture column, Fiscal Problems Loom, Even If Not a Cliff.

We haven't heard from any credible source who thinks a compromise will be reached before the presidential election.

The CBO has laid out an ominous case for what is likely to happen to the U.S. economy if we go over the fiscal cliff and a compromise is not struck. Recession is thy name.

Just about anyone who discusses the fiscal cliff falls back on the assumption that a compromise will be reached and that we will all be able to breathe a sigh of fiscal relief in due time. Sigh. That sounds good, but it can ultimately be exposed as a naive perspective.

Any compromise that is reached -- if one is reached -- does not necessarily mean it will be the right solution for the economy and/or the stock market.

The essence of the word compromise may be constructive, but make no mistake: a fiscal cliff compromise can still produce a destructive policy outcome.

That perspective is not in the market. What is in the market is the expectation that a compromise will be reached either in the lame-duck session of Congress, or soon thereafter, and that any compromise will only have a positive outcome.

Geopolitical Risk

When it comes down to it, the world is not a happy place -- at least not from the 10,000 foot view. That message gets played over and over again in political attack ads and it is heard nightly on local, national, and international news programs.

Humanity's civil nature has become increasingly uncivil in the face of difficult economic times, political gamesmanship, and religious fanaticism.

For good reason, the stock market's attention has been oriented primarily toward the eurozone and to any central bank meeting whenever one is held. That increasingly narrow-minded view of things, however, needs to be expanded, if for no other reason than the realization that central banks can't control geopolitical risk.

Stocks might be underpinned by the liquidity the Federal Reserve is providing, but that liquidity will flow out of risk assets quickly if Israel (with or without U.S. help) launches a pre-emptive strike against Iran's nuclear facilities or Iran takes action against Israel.

The saber-rattling between Israel and Iran has escalated in recent weeks, yet oil prices have dropped 10% in the last 14 trading sessions.

Separately, the risk of a military altercation between China and Japan is not in the market.

Nationalist sentiment can have a pernicious influence on trade. The world needs open markets. A military altercation over the Senkaku Islands would be disruptive to the Asian supply chain and it would invite an unnerving, diplomatic mess for the U.S.

China and Japan are playing a dangerous game of "Risk" in the East China Sea, and yet all the market cares about is whether or not China's central bank has cut its required reserve ratio.

Geopolitical risk is a perpetual risk factor for the market, but with the economic challenges as pronounced as they are, the market has been mostly inattentive to the geopolitical wild card. That sense of complacency currently makes geopolitical risk one of the biggest risk factors for the market, especially because it is a factor outside the Fed's control.

What It All Means

The U.S. equity market had a terrific showing in the third quarter. In doing so, it crossed a fundamental divide. It largely ignored weak economic data and an increase in earnings warnings, choosing instead to fixate on the notion that central banks can save the world and boost profit margins with their monetary policy.

Every other consideration was virtually irrelevant. Risks were highlighted, yet they were minimized by how the Federal Reserve said it would super-size its balance sheet.

There is a lot of faith in the Fed, and other central banks, right now. What there isn't a lot of is an appreciation for the element of negative surprise.

The risk of an adverse fiscal cliff outcome is not in the market. The risk of a serious geopolitical crisis is not in the market. The risk that fourth quarter and 2013 earnings will not live up to current expectations is not in the market. The risk of social upheaval in developed economies, including the U.S., is not in the market.

Risks for the most part have been blithely discounted by the market, which has an abiding faith in central banks, and primarily the Federal Reserve, to make things right. That is a risk in and of itself because the implementation of QE3 is proof that QE1 and QE2 did not produce the economic results everyone had hoped for when those programs were announced.

It is possible that the market will hold fast in the near term to the arm of a liquidity-driven trade, particularly since industry reports indicate many money managers are underperforming their benchmark. In the absence of any new negative surprises, that could be an invitation to performance chasing that pushes prices up into year end.

Still, it behooves investors to maintain some proper perspective at this point. Recognize that the market is riding a wave of liquidity and that it is not flowing in a current of fundamental strength. That liquidity trade could carry stock prices higher in the near term, but don't forget that all waves crest and then break.

It is hopeful to think that known risks will only have a positive outcome. It is prudent though to insure equity portfolios for the possibility that they will not.

Fortunately, the cost of hedging is inexpensive right now as evidenced by the VIX Index trading close to a five-year low.

Other specific actions to mitigate downside risk include:

  • Reducing exposure to high-beta stocks
  • Overweighting dividend-paying stocks with strong balance sheets that will allow for dividend growth in any environment
  • Trimming positions in big gainers within cyclical sectors
  • Adding to positions in counter-cyclical sectors; and
  • Raising cash

We certainly do not want something bad to happen, yet the fact of the matter is that the potential cost of a negative surprise has increased because the market is trading on the hope that only positive outcomes will occur with central banks standing watch.

Failing to protect against that rising cost could, in a manner of speaking, leave an investor's equity portfolio in deep senkaku if the element of negative surprise rears its historic head.

Source: The Cost Of A Negative Surprise Is Increasing