So Good, You Should Be Nervous

This article was written with Oliver Pursche, the Co-Portfolio Manager of GMG Defense Beta Fund. It was part of a series of articles developed under an agreement with to work with a variety of contributors and assist them in delivering actionable investment ideas each week.

NEW YORK (TheStreet) — We’re all feeling pretty good, and why not? There’s plenty to be happy about. The markets are up more than 10%. Economic data in the U.S. is improving almost as rapidly as the European debt crisis is fading. The turmoil in the Middle East, though roiling, never seems to attain the status of an actual crisis.

Unfortunately, markets are largely inert: They don’t look backward. They barely react to what is happening in the present. Any semblance of actualization they have is reserved for the future, for trying to interpret what is going to happen. And the future right now holds a hint of trouble that could deliver a repeat of 2011’s summer sell-off and market volatility.

It’s always something. This time however, it’s earnings. Specifically, earnings progressively weakened — ever so slightly — over the last three quarters. Fourth-quarter-2011 earnings (announced during January and February of this year) were their weakest since the market crisis of 2008. Among the venerable S&P 500, only 62% of companies beat earnings-per-share estimates, and only 57% beat revenue estimates. For context, bear in mind that’s roughly 10% less than the the same quarter a year ago, a figure that most analysts, economists and statisticians would call material. Worse than historical performance however is that future earnings estimates for 2012 — exactly the kind of stuff the market reacts to — are declining with the consensus (based on Bloomberg data) at about 10.4% growth in 2012, vs. 11.7% growth for 2011.

I’m not yelling “SELL” in a crowded theatre here. I am however telling investors to be on guard, and I’m going to arm them with a tool to pick up the scent of trouble before it’s too late.

Specifically, I am advising investors look carefully at the so-called “pre-announcement” activity at the end of March and the beginning of April. Here’s why: typically, companies begin to “pre-announce” (often poor) earnings at the close of a quarter to get bad news out of the way during market rallies. In late December and early January, of the companies that pre-announced earnings; 52% warned investors of disappointments.

My working thesis is that if we hit or exceed this number for the first quarter of 2012, the fix is in, and we are headed for some near-term trouble. And if this eventuality comes to pass, here are some stocks and sectors to consider as you assume a defensive posture.

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Retailers: Look to those focused on high and low-end consumers. Dollar Tree (DLTR) and Tiffany’s (TIF) are two favorites (we own DLTR).

Utilities: Nothing makes you feel safer than the steady pulse of energy coursing across the grid and leaving dividends and stable earnings in its wake, especially in troubled times. Entergy (ETR) and Exelon (EXC) are utility companies among our holdings.

Pharmaceuticals: Especially, big pharma. When the times get tough, consumers leave Carnival Cruise Lines at the dock for more important purchases such as Lexapro. Pick big pharma stocks with good growth and good dividends and you’re unlikely to go wrong as consumers favor discretionary spending for necessities. Abbott Labs (ABT) is one of our top holdings.

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