Lowered Outlooks Lower the Market

January 7, 2009

Wednesday's declines offer an important lesson in how to invest. The recent gains we've been enjoying since the holidays were pared back a bit on Wednesday, as Wall Street headed south thanks to bleak outlooks from some leading corporations and more gloomy employment news. When all was said and done, the Dow finished the day down 240+ points, or 2.7%.

Many people have asked me why the market melted down just because a number of companies lowered their forecasts. Yes, those stocks deserve to lose some ground–but why would other companies share in the declines?

Well, it all comes back to earnings. When Time Warner (TWX), Intel (INTC) and Alcoa (AA) all reduced their outlook on Wednesday, they were basically admitting that they were going to miss current earnings forecasts and signaling economists better move their projections lower. Basically, they decided to take the hit now instead of later when the precise numbers came out in their quarterly reports.

When a number of large-cap companies all lower their outlook, it tells the market that other companies are likely going to fall short of their forecasts as well. Investors who are afraid of suffering losses when earnings come out decide to sell now–and drive down prices across the board.

I always stress how important earnings season is because fundamentally strong companies post big earnings surprises and attract buying pressure. Similarly, stocks that miss forecasts suffer big declines as investors jump ship. Wednesday's sell-off was sparked by investors who were afraid their stocks would miss the mark–but don't forget the opposite affect is also possible! Investors who want to profit on strong quarterly reports will start bidding up a select group of stocks on the eve of earnings season.

Find out if your stocks have the fundamentals to succeed by checking out my free stock grading tool, PortfolioGrader.