There is a prevailing trend of short-termism in the market that has polluted the definition of what it means to be an “investor.” Investment time horizons for many are now defined in terms of days, weeks, and months rather than years. Furthermore, there now seems to be an emphasis on owning stocks rather than holding an ownership position in publicly-traded companies.

I attribute the shift in the investment time horizon and mentality to the delusional period of the Internet bubble, the commoditization and ease of stock trading, and the saturation of real-time news and commentary that comes with the in-your-face business TV programs, the mostly free domain of the Internet, and the rise of social media.

Real-time information is not a bad thing. In fact, it is a very good thing, assuming of course the real-time information is good information. However, we are now culture-bound with information overload that can – and does – make it exceedingly challenging for individual investors to maintain the conviction of their investment beliefs.

Separately, we are seeing retail investors disengage from the equity market, having been burned by two bear markets over the last ten years and punctuated by a genuine crash in equity prices between September 2008 and March 2009.

This is understandable as the return of capital has taken precedence over the return on capital. Still, it is bothersome to us because many of those investors probably missed most, if not all, of the 100% rebound off the March 2009 low and are now resigned to accept negative real returns in cash accounts that are a recipe for long-term underperformance.

With economic growth slowing in the world's major economies, it should come as no surprise that earnings growth is also slowing.

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.



Third quarter earnings are expected to decline 2.0%, according to the latest data from Thomson Reuters. That would be the first decline in S&P 500 operating earnings since the third quarter of 2009.

The negative-to-positive preannouncement ratio for the third quarter is 4.3. That is the weakest since the third quarter of 2001.



What is truly remarkable is that fourth quarter earnings 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 is 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.

Finally, there is no mistaking the fact that the equity market this summer was riding a wave of expectation that the Fed would provide further policy accommodation.

The chart below shows the divergence between the forward four quarter consensus earnings estimate, which was coming down as the second quarter reporting period progressed, and the S&P 500, which increased in price throughout the same reporting period as macroeconomic issues raised the likelihood of further easing from the Fed.

It is possible that capital gains and dividend taxes will increase effective January 1 -- and perhaps by a lot for upper-income earners. 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).

I 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 US 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 could still produce a destructive policy outcome or, at least, an outcome that is negative for the stock market.

The prevailing expectation today is 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. That is a risky perspective.

There is no denying that policy accommodation from the Federal Reserve has helped the equity market. What is clear in the chart below, though, is that quantitative easing has not been a panacea.

After QE1 ended, the S&P 500 declined as much as 14% over the next three months. After QE2 ended, the S&P 500 declined as much as 17% over the next five weeks. The former decline was precipitated by nettlesome developments in the eurozone debt crisis and the flash crash while the latter selloff was driven by the debt ceiling standoff in Congress.



The equity market recovered all that had been lost in both instances, helped in large part by better-than-expected earnings results and the underlying presumption that policy makers would step in with some form of stopgap stimulus.

Accordingly, with the eurozone debt crisis escalating to involve Spain and Italy and ongoing signs of a stalled labor market in the US, the stock market rallied this summer on the hope of QE3 and just about anything the ECB could conjure up to save the euro.

The S&P 500, however, is trading only slightly higher than the level it was at prior to the QE3 announcement on September 13, suggesting it benefitted from a buy-the-rumor tailwind leading up to that announcement.

Participants, though, haven't necessarily been selling the fact. That's because there is a strong hope that the open-ended, if somewhat conditional, pledge of policy support from the Fed and the ECB will reverse economic and earnings trends in short order.

We are not confident in that outlook for the simple reason that QE1 and QE2 didn't get the economic juices flowing; moreover, the fundamental support structure of earnings growth is weakening.

A lot of faith is resting on the Fed and its open-ended, QE commitment. We suspect the equity market will continue to cling to Fed policy in the near term as its main support structure, but the risk is building the longer the Fed stays involved in its unconventional manner.

That risk specifically is 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.

I have long maintained, and still do today, that stocks offer excellent relative value compared to alternative investments.

The forward earnings yield for the S&P 500 is 7.74% versus a yield of 1.63% on the 10-year Treasury note. Remarkably, the S&P 500 dividend yield of 2.00% is higher than the yield on the 10-year note.

The spread between the forward earnings yield and the 10-year note yield is referred to as the equity risk premium. That spread is currently 611 basis points (versus a 10-year average of 332 basis points), reflecting the higher level of risk in stocks amid all of the uncertainty in the world.



The equity risk premium is likely to remain elevated for some time yet, yet it is an opportunistic spread for investors with time on their side and the patience to assume more risk.

From this vantage point, we see the long-term value in stocks.

It is the near term that concerns us the most, because the market is riding a big wave of hope that only positive outcomes will be seen with the Federal Reserve standing watch.

The S&P 500 has risen 14% since June 1 and things are not good -- at least not from a fundamental standpoint. Economic conditions around the globe are softening and earnings growth is decelerating. Third quarter earnings, in fact, are projected to decline 2.0%, which would be the first decline since the third quarter of 2009, on revenue growth of just 0.1%.

Why then is the market in rally mode? It boils down to three words: central bank support.

Major indices have ridden a big wave of liquidity to multi-year highs. What investors need to remember is that big-wave surfing is fraught with risk and can bring a lot of pain if the surfer loses perspective and balance.

There is no telling for sure how the fourth quarter will unfold. What we know is that market risk is increasing as the fundamental divide between the real economy and the hope of central bank support widens.

I urge investors to keep their perspective and balance. Riding the liquidity trade can be profitable and exhilarating, but take care to ensure that your equity portfolio can withstand a rogue wave.

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 US, 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 nonetheless that the market will hold fast in the near term to the rm 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 liquidity trade could carry stock prices higher, but bear in mind that fundamental conditions are weakening and that the market is being driven by an expectation that only positive outcomes will occur with central banks standing watch.

History has shown that central banks are not infallible. It makes sense, therefore, to ensure equity portfolios are balanced to protect against known risks taking an unexpected turn or the rogue wave that topples the market's belief system in the Federal Reserve and its central bank cohorts.

Valuation favors the long-term investor, yet near-term risks are abundant right now which makes the argument for adopting a more defensive-minded tactical strategy a reasonable one. That will mean different things for different people. A general approach for doing so could 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
• Hedging through the use of options to protect against downside risk; and
• Raising cash