Why Stocks May Swoon for the Rest of 2012

Problems in Europe--and Washington--may finally be taking a bite out of corporate profits.

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Despite a lot of nervous twitching, stock markets have been surprisingly resilient this year, with the S&P 500 index up about seven percent so far in 2012.

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But the rally may finally be ending, with the second half of the year starting to look considerably gloomier than it did just a few weeks ago. The direction of the stock market on election day could be one of the swing factors in the tight presidential race between Barack Obama and his challenger Mitt Romney.

Corporate profits, a bright spot for the last few years, are leveling off and in some cases coming in surprisingly weak. One reason: Financial woes in Europe and other global hotspots are starting to drag down corporate earnings. And the coming post-election showdown in Washington over tax hikes and spending cuts is already starting to depress economic activity. "The market focus will shift to worrisome macroeconomic trends," writes Dick Green of Briefing Research. "The markets will also have to face the very real prospect of turmoil from political gridlock."

Investors have worried for months that European debt problems and the sharp slowdown there will push down overall corporate earnings and stock prices. That may finally be happening. McDonald's, for example, startled analysts recently with a weak second-quarter earnings report, partly because of lower-than-expected sales in Europe. Sales in emerging markets such as Asia, Africa and the Middle East were weak as well, possibly because those regions are tied to the sick European economy.

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Some analysts have also detected a worrisome slowdown in revenue at big firms. More than half of the S&P 500 firms reporting second-quarter earnings so far have reported lower revenue than forecast, which means they're falling short of the top-line sales analysts expect. "That should be raising red flags," says Green. "The revenue misses indicate that underlying company fundamentals are worse than expected."

During the recession, many companies stayed profitable even though revenues fell, because they were able to cut costs by more than revenue in order to protect their profit margins. But a lot of firms are now about as lean as they can get, with very little left to cut. So if revenue stagnates or falls, profit will probably do the same—a recipe for falling stock values.

Investors have vacillated between hope and fear for most of 2012, as they've tried to figure out whether to gamble on a broad economy recovery that would push stocks upward, or protect their capital in the event of a rout. But they may still be projecting too much hope and too little fear. Bank of America Merrill Lynch recently pointed out that stock analysts have cut profit forecasts for the second half of 2012 by about two percent over the last couple of weeks, with more cuts likely. Merrill thinks profit forecasts for the rest of 2012 are still five percent too high.

Meanwhile, companies and consumers are girding for the big fight coming in Washington over a huge set of tax hikes and spending cuts that will go into effect in 2013 if politicians don't prevent it from happening. With the stakes high, many assume Congress will reach some sort of bipartisan compromise so that Washington doesn't tumble over the "fiscal cliff." Yet the uncertainty over what will happen is already starting to weigh down the economy. "There's an enduring diminution of growth because of the fiscal outlook," says Peter Fisher of the investing firm BlackRock. "We already see the negative impact on household and corporate confidence."

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With skeptical businesses reluctant to hire and nervous consumers reluctant to spend, a self-reinforcing doom loop could depress stock prices right up to the November elections. Since stock values directly affect the mood of consumers watching their investment portfolios go up or down, a dip in stocks would be bad news for President Obama, as he tries to persuade voters to sign on to four more years of his economic policies.

One thing that has boosted stocks before is quantitative easing by the Federal Reserve, and there's a chance the Fed could ease again by the fall. But most investors feel the Fed's medicine becomes less potent every time it administers a dose. So measures that have driven stocks higher before may fail to work the same magic this year. That's a theme we ought to get used to.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.