After yesterday's extensive esoteric exploration of investing philosophy, I decided that I'd better climb down off of the soap box and talk about something a bit more concrete in this morning's missive. And while I'm not a big believer in investing based on one's view of the world, I thought it might be a good idea to take a look around to see what might interrupt the bulls' current joyride to the upside. In other words, I'll be asking the question: What could go wrong from here?
Right now it is fairly easy to bullish. The Dow has been up 11 of the last 12 days. The DJIA, Mid- and Small-cap indices all made new all-time highs yesterday. Money is coming into mutual funds for the first time in years as it seems the press has convinced the public that a new high is the same thing as an all-clear signal. The Bernanke Fed (as well as most of his foreign counterparts) is keeping rates low and has promised to keep them that way for quite some time yet. Earnings are approaching record highs. Inflation is low. The economic data has been B.T.E. (better than expected) across the board lately. There is talk of funds rotating out of bonds and into stocks. So in short, what's not to like?
Three weeks ago, the general sentiment toward the stock market was something akin to fear and loathing. However, all the talk about new highs seems to have created a shift in people's attitudes as our sentiment indicators now suggest there is entirely too much optimism out there. The cheerleaders like Jim Cramer are giddy with excitement. CNBC can't create new countdown tickers fast enough to keep up. And assuming the S&P kept up the current pace, it would finish the year with a gain of more than 35%. Booyah indeed.
So, what could go wrong from here, you ask? Plenty. First and foremost is the fact that Wall Street and its computers do enjoy a good repeatable trend. So, given that this is the fourth year in a row that stocks have started off strong and that employing a “sell in May and go away” strategy has been effective each and every year (at least to some degree) since 2006, I think it is a safe bet that the bears might find a way to make a comeback at some point in the next month or so.
However, I'm also the guy who has been yammering on about the idea that the bears are going to need a catalyst in order to start dancing to the downside in earnest. So, let's talk about some of the things that could spoil the bulls' expectations for a straight-up year.
One of the most obvious things that could become a problem for stock prices (at least from a short-term perspective) is if the economy exits the Goldilocks zone and begins to heat up. Recall that I have opined recently that the economy will be just fine, thank you, as long as a new crisis doesn't appear. So, if there are no external shocks this year such as a financial crisis, a Tsunami that threatens one of the most populated places on the planet, a new uprising in the Middle East, or the demise of the euro, then I'll bet the economy can improve – which, of course, would be a good thing.
But, if the economy really starts to roll and companies start to hire again, then the Goldilocks scenario, where the economy isn't hot enough to cause inflation or the Fed to pull the punch bowl and not cold enough to cause concern about a recession, would have to be shelved. In short, interest rates would likely begin to rise faster than the Fed could (try as they might) control them. And while a stronger economy is indeed a good thing in the long run, a spike in rates could be a problem for the stock market as any company with a lot of leverage would clearly be negatively impacted.
Next up is China. Although a growth rate of 7.5% may be enviable to most nations, China is trying to walk a fine line at the present time. You see, the country needs to create growth in order keep their people working and maintain order. Yet at the same time, the combination of strong growth and low interest rates is creating something of a bubble in real estate prices. Thus, the government is trying to keep economic growth up while putting a lid on real estate prices. To say this is a tricky situation is obviously an understatement. So, if China brakes too hard, their economy could slow too fast, which, in turn, would impact global economies – and not in a good way. But if they don't rein in real estate prices, well, we all know how that movie ends.
Then there is the budget battle in the United States. Although the two parties have agreed to take a step back and tone down the rhetoric at the present time, this doesn't mean anything's been solved. And just this week a rumor that Moody's is getting ready to downgrade our credit rating sent stocks into a tailspin over a 30-minute period. So, if Washington can't figure a way to work this thing out, then debt downgrades are a distinct possibility later this year.