Risk Factors
Since 1928 the S&P 500 has registered a yearly gain 66% of the time. It is only fitting then that investors naturally possess a bullish bias when contemplating the stock market outlook.
That natural tendency has been challenged, however, with two, massive bear markets in the last 10 years alone. The biggest challenge perhaps to that natural bias was the realization in early 2009 that the S&P 500 had plummeted to a level that was also seen in 1996, thereby challenging the virtues of buy-and-hold investing.
The market has of course come bounding back from that lowly level and, despite still being down 30% from its all-time high, has ignited some animal spirits again in the investment community.
Oh, how we wish every investment year could go like this one did after the market hit its low on March 6.
The truth of the matter is that no one knows how any investment year will go. Forecasts are issued and confident declarations are made on TV by prognosticating pundits, but when it comes down to it, the best anyone can do is provide an educated guess as to where they think the market will likely go.
Our educated guess is that the market will achieve a single-digit to low double-digit percentage return in 2010, with the first half of the year looking better than the second half of the year in terms of performance.
However, since no one knows the future and since the behavioral finance machine that is 'the market' can shift on a dime, investing is inherently imbued with risk.
With that, we turn our attention to a number of factors that could pose a risk to the positive stock market outlook. We are not forecasting that they will happen, but we are generalizing that if any of them came to fruition, the stock market outlook could tip in a different direction.
--Patrick J. O'Hare, Briefing.com
Risks:
The unknown
We might as well get this risk out of the way first. The unknown coming to light is a notorious source of volatility since it produces uncertainty that, in turn, can provoke panic selling if the unknown factor cuts to the heart of conventional wisdom (e.g., the U.S. is not at risk of a major terrorist attack).
The impact of the unknown on the stock market will be proportional to the perception of the risk it poses to the real economy.
(Note: invoking the unknown factor as a risk for the stock market outlook gives pundits like us a convenient way to say 'we told you so' when the unknown factor was not part of a list of risks previously presented.)
No buyers of MBS after Fed exits
If the Federal Reserve stays true to its word, it will have essentially completed $175 billion worth of agency debt and $1.25 trillion worth of agency mortgage-backed securities by the end of the first quarter.
In an effort to ready the market to function primarily on its own accord, the Fed is reportedly slowing the pace of its purchases already. The Fed's exit from the MBS stage could very well be the market's first true test in 2010. The behavior of the MBS market after March 31 will send a signal as to the economy's readiness to stand on its own two feet.
If MBS yields track higher because of lackluster private demand for the securities, mortgage financing rates will press higher and interfere with recovery prospects in the housing sector.
If home sales slow, or decline, because of the higher cost of financing or a lack of funding, concerns will build about the sustainability of the rebound in the broader economy and the validity of rising earnings estimates for 2010.
Weakening dollar triggers trade war
There has been considerable attention paid to the weakening dollar and the benefit it is providing the U.S. in foreign trade. China is also benefitting in the export economy since its currency is pegged to the dollar.
Countries whose currencies are strengthening on the back of the dollar's weakness and interest rate differentials are apt to become increasingly hostile over the loss of competitiveness against U.S. and Chinese exports.
Continued weakness in the dollar will likely lead to competitive devaluations in the currencies of export-dependent countries and/or the increased use of tariffs to combat the competitive disadvantage.
Carry trade collapses
With interest rates at the zero bound in the U.S., the dollar has become a popular source of funding for carry trades in which traders use borrowed dollars to invest in higher-yielding assets.
A flight-to-safety to the dollar, triggered by some exogenous event, could lead to a disorderly unwinding of leveraged positions in higher-yielding assets as traders attempt to stem the increased cost of repaying dollar-funded trades.
Separately, a fundamental strengthening in the dollar that flies against conventional wisdom could also be a catalyst for a volatile unwinding of carry trades.
Deficit trends in wrong direction
In its mid-session review, the Office of Management and Budget raised its FY10 deficit estimate projection from $1.26 trillion to $1.50 trillion (the government ended FY09 with a $1.42 trillion deficit). With the current expectation that the deficit will widen slightly in FY10, it is clear that 2010 is shaping up to be another challenging year for the government as tax receipts remain depressed in the face of a double-digit unemployment rate.
States are also under a great deal of budget pressure and could require more assistance from the federal government to plug shortfalls than originally thought. By and large, there is not any real room in the federal budget for major spending surprises.
A deficit moving well above current estimates will be a disconcerting point for U.S. creditors (and ratings agencies) who are likely to demand higher rates of return to help finance the deficit. Higher rates will be a retardant on U.S. growth.
Terrorism
The threat of terrorism is omnipresent in the wake of 9/11.
Popular events with global reach, like the Winter Olympics and the World Cup, are generally considered to provide an opportune time for a terrorist attack. If a terrorist act were committed at either of these events, one could expect to see some knee-jerk selling interest that gets overdone, especially since large-scale terrorist acts have been fairly well contained since 9/11.
The lasting impact on the stock market of a terrorist act, though, depends largely on the economic damage it does. Terrorist acts at either the Olympics or the World Cup would be shocking in nature, but presumably more so from a human standpoint than an economic one.
Economically-speaking, a terrorist act in the U.S. that strikes at our sense of normalcy (e.g., bombs on buses, in restaurants, at movie theatres, etc.) would be the most damaging since it would feed a nesting trend among U.S. consumers who continue to be the most important driver for the global economy.
Natural disasters
We can do our best to contain Mother Nature, but we cannot stop her in her full fury as Hurricane Katrina demonstrated to the world. Similarly, we have no control over earthquakes, tsunamis, or blizzards.
We have tools that help predict these things and can offer early warning signals, but natural disasters always have the potential to be a freak of nature that can upset the economic outlook in a meaningful fashion by obstructing the transportation of goods, feeding a spike in commodity prices, and/or lowering consumer spending activity.
The arrival of higher tax rates
Barring any changes by Congress, the maximum long-term capital gains tax rate is due to jump from 15% to 20% beginning Jan. 1, 2011, and dividends will be taxed as ordinary income at one's highest marginal tax rate.
Income tax rates, meanwhile, are all slated to go back to where they were prior to the signing of the Economic Growth and Tax Relief Reconciliation Act in 2001.
Beginning in March, early entrants in the recovery rally will be eligible to take long-term capital gains at the lower tax rate. There could be a progressive uptake on that strategy as the year unfolds, particularly if the economy and stock market are sputtering in the back of 2010 and this tax break is not extended.
Passing a financial transactions tax
There are compelling arguments on either side of the debate dealing with imposing a financial transactions tax. The aim of such a tax, reportedly, is to curb speculative trading activity and to create a source of tax revenue that could help pay down the deficit.
The imposition of a tax on financial transactions would presumably be regarded as a negative by the market if for no other reason than it would create uncertainty about its impact on trading activity in the short-term and long-term.
Japan steps up selling of its Treasury holdings
With $746.5 billion in Treasury securities as of the end of October, Japan trailed only China ($798.9 billion) as the largest foreign holder of U.S. Treasuries. These holdings represent a ready source of funding to help Japan pay down its hefty debt, which is approaching 200% of GDP as Japan increases stimulus measures to boost its economy in an attempt to prevent a deflationary spiral.
With the run Treasuries have had, and the thinking that there is a lot more downside on price than upside at this juncture, Japan may see this as an opportune time to capitalize on those high Treasury prices to better its own fiscal situation and to keep ratings agencies at bay.
The dilemma for Japan is that repatriating proceeds from the sale of U.S. Treasuries would strengthen the yen. A stronger yen is a negative for Japan's exporters and would be a retardant on Japanese growth. The currency factor would be less of a dilemma if global economic activity grew strongly on a sustained basis.
Japan selling debt on a larger scale is likely a low probability event, but it would be an upsetting event if there were not ready buyers to soak up the excess supply.
China tightens stimulus measures
A great deal of hope and capital has been pinned on China as being the savior of the global economy.
China has certainly done a commendable job of stimulating its economy through a most difficult period, but if it subsequently steps up measures to cool down its growth in an effort to prevent asset bubbles from forming and/or to guard against importing inflation from the Fed's loose monetary policy (since the yuan is pegged to the dollar), it could result in a disorderly flight of capital from emerging markets.
A cascade of selling in emerging markets should benefit the U.S. Treasury market, the dollar, and, to a certain extent, the U.S. stock market.
Nonetheless, if China took steps to slow its growth before the U.S. economy was perceived to be on sound footing, the default trade would be predominately oriented toward seeking safety in the Treasury market.
Housing recovery turns into housing relapse
Sales of existing homes bottomed in January 2009 (at least we hope they did) at a seasonally adjusted annual rate of 4.49 million units, roughly 38% below the peak of 7.25 million units seen in September 2005.
In October, existing home sales climbed to an annual rate of 6.10 million units, which was up 23.5% versus the year-ago period. The median sales price of $173,100 in October, however, was still 7.1% below the year-ago period.
Low prices, low financing rates, and the first-time homebuyer tax credit have been successful in stoking demand, but can that demand persist?
A downturn in the housing market, which is in the realm of possibility if interest rates go up and the labor continues to be weak, would undermine economic growth expectations for 2010.
Double-digit unemployment rate lingers
A 10% unemployment rate does not sit well with anyone. It is particularly troublesome for the individuals who are in the deep pool of workers counted officially by the Bureau of Labor Statistics as being unemployed.
High rates of unemployment are a natural weight on consumption and a natural catalyst for a change in the balance of political power.
The risk of a double-digit unemployment rate will hang over the midterm elections. It will also hang on the minds of current workers, who fear they may soon lose their job, and the minds of unemployed workers who think there are not any good-paying jobs available.
If the labor market does not show encouraging signs of recovery (e.g., pickup in the avg. workweek, increased use of temporary workers, declining trend in initial claims, etc.), the high unemployment rate will be a well-documented marker that depresses spending and slows the housing recovery.
Geopolitical conflict
China attacks Taiwan.... Israel attacks Iran (or Iran attacks Israel)... North Korea invades South Korea. The conflict scenarios can go on and on, but scenarios such as these coming to fruition would be particularly harmful to markets around the globe.
We suspect the most troublesome conflict from an economic standpoint would be a military conflict between Israel and Iran since that would ultimately lead to a spike in oil prices.
A bear market in Treasuries
Whether one thinks the Treasury market is a bubble or not, a collapse in prices there that produces a marked upward shift in yields would be detrimental for economic, and earnings, prospects.
The cost of financing would go up for businesses and consumers alike which, in turn, would raise the risk of default for both groups in the event they need to roll over maturing debt.
A spike in Treasury yields that is the result of a lack of demand due to pressing concerns about the U.S. fiscal situation would be particularly onerous if the U.S. economy is not growing at its full potential. Higher Treasury yields in this instance could be a catalyst for a double-dip recession.
Sovereign debt default
With the resurgence in equity prices around the globe and the narrowing in credit spreads, a sense of complacency about the recovery has made its way into the marketplace.
A development like a default on sovereign debt would upset that sense of complacency and create a good deal of uncertainty about the financial/economic impact of that default and what country might be next in the default line.
The dollar would benefit from a rush to safety which, in turn, could cause additional unrest if that were to force a disorderly unwinding of dollar-funded carry trades.
Politicized policymaking
Increased regulation and oversight is the political order of the day in Washington, as lawmakers work to stem the possibility of another financial crisis like the one just experienced. There is a risk at a time like this, though, that Congress overplays its hand and does more harm than good for the economy and capital markets by doing what is popular as opposed to doing what is right.
Congress treading on the Fed's independence in setting monetary policy would be an example of doing what is popular as opposed to doing what is right.
Regulatory reform is certainly needed in some instances, but the bottom-line is that the more restrictions that are placed on how business is conducted, the less opportunity there is to maximize profit potential.
Lower profits means less hiring. Less hiring means less spending. Less spending means less growth potential.
Another banking crisis
It is hard to contemplate the idea of another banking crisis when the last one has yet to be fully resolved. Therein lies the risk. Having to deal with another crisis risks undoing the recovery that has already been established and further forestalling the ready extension of loans.
A sovereign debt default, another downturn in the housing sector, greater-than-anticipated losses on commercial real estate -- these and any other number of factors would create a crisis of confidence in the banking sector and stir concerns about systemic risk that would be projected in lower stock prices.
Commodity inflation without growth
Some degree of commodity inflation goes hand in hand with economic growth; however, commodity inflation without growth poses a risk to the economic outlook.
The dollar's behavior is a key thing to watch regarding commodity inflation. A weakening dollar would be supportive for commodity prices.
Geopolitical unrest, natural disasters, and trade wars are other elements that could stoke commodity inflation without a fundamental pickup in demand tied to a growing economy.
Fed miscalculates with policy decisions
Fed Chairman Bernanke has offered repeated assurances that the Fed has the policy tools at its disposal that can effectively shrink the money supply before inflation gets out of hand. The trick for the Fed is knowing when to use those tools.
If the Fed takes away stimulus measures too soon, it risks inviting a double-dip recession. If the Fed waits too long, it risks unleashing higher inflation and higher inflation expectations.
The task of unwinding the stimulus will be more challenging for the Fed than the task of providing the stimulus when the credit market was frozen.
Much is at stake and the Fed's actions -- or lack thereof -- will present an ongoing risk for the market as participants debate whether the timing of the Fed's policy decisions is right.
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