This market is surely a head-scratcher. Stocks have trended higher for more than three years, even as the United States remains in an economic funk and corporate profits are slowing. The market seems to be ignoring the possibility that if the U.S. economy slumps badly in 2013, then it could lead some investors to draw a fresh conclusion: sales and profits don’t matter.

Well, history says otherwise. 

Growth and valuation measures always come to dominate the market — eventually. In the short-term, the market can be influenced by exogenous events such as the possibility that the Federal Reserve may stimulate the U.S. economy. With the market hitting new multi-year highs, it’s time to take a fresh look at the numbers and see what we can learn about the market’s likely performance in the quarters ahead.

The distant memories of the Great Recession
For just a moment, let’s forget about the scary moments of 2008 and 2009. Most investors surely did, as the S&P 500 rebounded from below 700 in March 2009 to above 1,100 at year’s end, retracing almost all of the era’s losses. Yet from the start of 2010, the S&P 500 has risen 29%, which works out to be a roughly 10% annualized gain.#-ad_banner-#

With the S&P 500 now at 1,435, it’s worth assessing what this figure means in the context of corporate profits (and profit growth). Because, as I said, this is what really moves the market — and will have the biggest impact on your portfolio — in the long-run.

Aggregated earnings in the S&P 500 hit $97.60 in 2011, which means the index trades for 14.7 times trailing earnings. That was the third-straight year where earnings grew at least 15%. 

But that’s about to change.

Forecasts for aggregated earnings per share in the S&P 500 in 2012 now stand at about $104, representing around 8% profit growth. What about 2013? Analysts, always an optimistic bunch, currently predict that earnings  for the S&P 500 could rise more than 10% to roughly $116 per share. Yet it’s hard to see how this can be accomplished in this slow-growing economy. That outlook is “is more consistent with GDP [growth domestic growth] acceleration, which we find highly unlikely,” noted analysts at Morgan Stanley, who foresee 2013 S&P 500 earnings of just $100 per share. 

Their dim profit outlook still assumes the U.S. economy will grow at a 2% pace in 2013, as many economists currently anticipate. “In fact, it really doesn’t take into account the fiscal cliff in any way, meaning downside to our base case is likely,” they add. These strategists actually say earnings could drop to $81 a share if the current path of the fiscal cliff is not altered. 

I discussed the fiscal cliff two months ago and nothing has changed since. Washington D.C. is consumed with the upcoming elections, so this issue will still be a threat come November. What will happen after that? Lawmakers will probably step in, either in the lame duck period before the next presidential inauguration or soon thereafter. 

In all likelihood, the fiscal cliff won’t bite as deeply as is currently planned. But it will have some bite to it. You can count on some degree of further spending cuts and tax hikes, which will be helpful in tackling the U.S. budget deficit, but will nonetheless act as a brake on the economy. 

In that light, it’s pretty hard to see why analysts say that S&P 500 profits will rise more than 10% in 2013. And as profit forecasts start to get marked down, the still-rising S&P 500 may finally hit the headwinds that some have been expecting for quite some time.

S&P 500 Performance

There is a notion that “the market always looks ahead,” which means today’s stock prices are based on the future direction of profits. That’s worth thinking about if S&P 500 profits in 2013 fall below the levels seen in 2012, as the Morgan Stanley analysts predict. What do the numbers say? On the 12 occasions when S&P 500 profits have dropped from the prior year since 1970, the market has dropped in anticipation of that event on six of those occasions. The average return in these years is a 1% loss. So in that context, this year’s 12% gain for the S&P 500 thus far appears misplaced.

Risks to Consider: As an upside risk, global investors are having a tough time finding value elsewhere and may increasingly look to park their money in our stock market, thanks to its perceived stability.

Action to Take –> This is not a call to avoid stocks. Instead, it’s a fresh reminder that playing defense becomes essential as the market hits fresh multi-year highs. That means stocks with solid support in the form of solid dividend yields, cash-rich balance sheets, or a history of solid free cash flow in any economic climate.