What Will Crash the Stock Market in 2011?

NEW YORK ( TheStreet) -- The equities market stampeded out of the gates on the first day of trading in 2011, almost as if the act of ripping the pages of another year off the calendar could keep troublesome economics issues from bleeding into the ink of 2011.

Investors know better, and came back down to the sober reality of earth, and up-and-down markets, on Tuesday, when even the release of more positive data about the U.S. economy couldn't keep the markets from taking a small step back.

The economic data that came in toward the end of 2010 was no doubt encouraging, and the improving trend is expected to pick up where it left off in 2011. It's done just that so far, with the economic data released on Monday and Tuesday showing gains made by the U.S. economy and, in particular, the manufacturing sector. Yet to be lulled into the belief that U.S. and global economic sore spots have been effectively neutered as a new year commences, would be like thinking a day without Julian Assange in the news means that Wikileaks is no longer an issue for loose-lipped diplomats or Bank of America stock.

Yes, economists are rosy on 2011. Finding an economist who doesn't expect the S&P 500 to rise again in calendar year 2011 is like trying to find a business executive who thinks President Obama is the best friend of corporations.

Indeed, the most hopeful sign for investors may be that for all the economic woes in 2010, it didn't turn out to be a bad year at all for the market. The S&P 500 closed the year up close to 13% and the Dow Jones Industrial Average wasn't far off that pace. Record corporate profits were recorded in the second half of the year also.

If the improving economy is most notable when considered in light of all the potential pitfalls, it's also an indication that many of those 2010 pitfalls remain plotted on the 2011 landscape.

Those temporary workers hired by retail chains to hawk holiday specials aren't likely to find themselves the recipients of permanent jobs selling 50%-off argyle sweaters or LED flat panels.

Those lingering, fearful whispers of a double dip still to occur in a certain area of the U.S. economy synonymous with great rooms and granite countertops could be more accurately described as a 12-layer dip of mass indebtedness.

The lack of property taxes being counted out on those granite countertops means that from sea to shining sea, across amber waves of grain and up to purple mountains' majesty, capitol domes and city halls are making desperate pleas to take pity on their broken balance sheets and teeter-totter economies.

On the global front, the knives-of-austerity budget butchers will continue to be as sharp as the knives used in four-star Michelin-rated Parisian gastronomical gems.

In Asia, inflation tamers don't just find themselves in the cage with a safari variety lion, but a veritable dragon that needs to be beaten back with the whip and chair in 2011.

And if that isn't enough to lead to a bit of nail-biting on those greedy fingers, think flash crashes and technical trading indicators -- say, a certain famously tragic and highly explosive German airship -- that materialized out of thin air in 2010 as signs of mere market anarchy about to be loosed on the world of investors. Think there's nothing to worry about?

Click on for the key suspects for Market Threats of 2011...

2011 Market Threat No. 1: The European Union

It may no longer be a case of 13-year-old hemophiliacs ruling by divine right, but the European Union is still as fine a mess as the most in-bred royal families of the Continent's yesteryear.

Indeed, if there was one 2010 headline which a markets reporter could close their eyes and hit send on without even bothering to check the date on the calendar, it was something along the lines of "European sovereign debt woes sink markets." The plate of 2011 euro forecasts from some of the biggest banks and securities firms is not a comfort food for investors either.
  • HSBC's director of currency strategy, Paul Mackel, told Reuters as 2010 drew to a close that the euro still has room to weaken.
  • Bond investing giant Pimco told Dow Jones near the end of 2010 that the euro will still fall 10% against the dollar in coming months, to the range of $1.10 to $1.20.
  • A Bloomberg analysis of what it considers the most accurate currency forecasters also showed a poor outlook for the euro extending well into 2011.
  • Standard Chartered, ranked by Bloomberg as the top overall forecaster in the six quarters ended Sept. 30, predicts that the euro may weaken to less than $1.20 by mid-2011, in line with Pimco's expectation.
  • BNP Paribas, the fifth-most accurate forecaster in the Bloomberg rankings thinks the euro will trade at $1.25 by the end of June and $1.20 in the third quarter.
  • Meanwhile, problems in Ireland, Portugal and Spain, just to name a few of the EU bad actors, are going to continue in 2011.

    Granted, if the markets were able to ride out the EU crisis in 2010 when Greek citizens were rioting in the streets and German chancellor Angela Merkel probably felt like the only offspring of a European dynasty that hadn't thrown away her inheritance on yachts and vineyards, maybe the market can abide short-term weak spots for the euro throughout 2011.

    It should be noted that the median mid-2011 euro forecast of 41 strategists surveyed by Bloomberg has the vulnerable currency rising to $1.36 next year -- far from a currency-crash scenario.

    In the least, you can expect that the EU crisis will make for convenient business news headlines when a financial journalist can't think of another reason why equities are declining.

    But this hardly means that the market is going to starve for lack of other profligate spenders from among the ranks of public entities....

    2011 Market Threat No. 2: The Municipal Bond Market

    It's the state and local governments right here in the good old US of A that are going to be laying off workers and putting up the foreclosure signs on city hall lawns and above capitol domes in 2011.

    Or at least, so say 60 Minutes and oft-quoted financial services analyst Meredith Whitney. They are not alone, though.

    With New York Governor Andrew Cuomo saying this week that he would take a 5% pay cut, it seemed the public-sector equivalent of Citigroup CEO Vikram Pandit vowing to only be paid $1 until his bank returned to profitability. And we don't simply mean equivalent in terms of a top dog falling on his own sword. Let's keep in mind that Cuomo would not have had to take a pay cut if he wasn't also freezing state worker salaries and trying to close a $10 billion budget gap in New York.

    These are moves being made from a position of economic weakness and should make an investor somewhat nervous.

    State and local governments across the country are planning a big pushback against labor unions this year as a way of cutting into the huge budget shortfalls. The New York Times reported on Tuesday that some states are now considering legislation to sap labor unions of their power to contest austerity measures that will directly hit workers paychecks.

    In Wisconsin, new governor Scott Walker is not only contemplating similar moves to the ones made by New York Governor Cuomo, but is considering legislation that would remove the right for state employees to form unions or collectively bargain.

    California, with a budget shortfall of $25 billion in the next two years, has been the poster-child for the state and local economic ticking time bomb. New Governor Jerry Brown is now considering what was once unthinkable for an old California "lefty": austerity budget measures that put one in the mind of fiscal conservative think tanks.

    As Bank of Tokyo-Mitsubishi UFJ senior U.S. macro economist Ellen Beeson Zentner put it, "State and local finances are in shambles and there are no property taxes from the housing market which used to be a huge source of income. You can't run a deficit like the federal government can and unemployment programs are killing them."

    In California, Brown may be forced to continue policies begun under the Terminator that took aim at hefty pension packages of state retirees, and even consider raising the retirement age.

    Where have we seen similar issues play out in 2010 and topple the market? Remember those Greeks violently rioting in the streets when their prime minister planned steep cuts to pensions and salaries, and the French going on strike -- well, when aren't the French on some type of strike -- when French President Nicolas Sarkozy undertook his campaign to raise the mandatory retirement age for French workers from, oh probably 25 or so, to 62.

    Indeed, is the U.S. state and local government crisis the EU of 2011?

    Even if not, the worst is yet to come. "The private sector has been paying in blood for a good two years before the governments even came to grips with the crisis and started laying off workers. When the coffers can't even be described as dry, but are like the Mojave Desert, muni defaults will stay at the forefront, and people who think it can't happen are missing the boat," the Bank of Tokyo-Mitsubishi UFJ economist warned.

    Governor Cuomo could reduce his salary to 1 euro, and it still might be wise of investors to steer clear of municipal bonds, and for Cuomo to convert that paycheck into some other currency, in a hurry.

    2011 Market Threat No. 3: The U.S. Foreclosure Pipeline

    If a capitol dome or two may need to be pawned in 2011, a big part of the problem, as noted in the aforementioned fear mongering about the municipal bond market, is the lack of property tax income stuffing the coffers of state and local governments. This circles back around to the one U.S. economic problem that was at the forefront of the worst recession since World War II and will continue to wreak havoc with U.S. economic sentiment.

    For all the recent improvement in pending and existing home sales data, there was the S&P/Case-Shiller most recent home price index report, released in the last week of December -- and again resulting in rising fears about a double dip in the U.S. housing sector.

    Bank of America ( BAC) agreed this week to take a charge of $3 billion to put to rest the lingering issue of toxic mortgage assets it unloaded on Fannie Mae and Freddie Mac.

    There were also several reports this week that the probe into the foreclosure practices of major banks, including Bank of America, would soon be settled between the state attorney generals and the banks: Bank of America, JPMorgan Chase ( JPM), Wells Fargo ( WFC) and Ally Financial among the most prominent financial companies implicated in the latest mortgage scandal.

    Even if robo-signers and toxic mortgages leave the headlines, foreclosures could be poised for their peak year in 2011. In fact, the robo-signing scandal led to a freeze in many foreclosures that will now spill over into 2011.

    In the words of Wells Fargo senior economist Mark Vitner, "There's continued uncertainty about the timing and number of foreclosures, but I really expect foreclosures to pick up next year."

    Some have described the coming "tidal wave" of foreclosures. Pick whatever poisonous metaphor you prefer.

    Foreclosure watchdog RealtyTrac noted in its most recent monthly foreclosure report that activity had decreased 21% month-over-month and 14% year-over-year, representing the highest drops recorded since RealtyTrac began publishing the U.S. Foreclosure Report in January 2005.

    Whether it's a tidal wave or monsoon of mortgages, that was the calm before the 2011 storm. The bulk of three- to five-year adjustable rate mortgages hit the foreclosure pipeline in 2011. RealtyTrac is predicting a record year for foreclosures in 2011.

    The good news, if there is good news about the U.S. housing market, is that the continuing problems are well-telegraphed, and estimates for true recovery in the housing sector range anywhere from one to three years out. If there's a major U.S. economic issue that's not going to get better soon but shouldn't surprise anyone, it's this one.

    2011 Market Threat No. 4: U.S. Unemployment

    The $858 billion tax cut/economic stimulus is supposed to trigger more hiring by the corporate sector. Recent record levels of corporate quarterly profits were notable not just for the sheer numbers, but because companies were doing more with less. Productivity gains after mass layoffs and operation streamlining can provide earnings with a quick boost as an economy recovers, but the impact isn't lasting, and at some point, companies need to start hiring again to keep the economy moving forward.

    Corporations have still been tying the purse strings tight. While stock repurchases were all the rage for corporate managers in 2010, the more aggressive act of hiring again was not a part of the corporate playbook. That's got to change, and the first indication of any change may come from the January earnings reports, when C-Suite executives reveal their 2011 sentiment and strategy.

    There are only two ways corporations can continue to improve profits: by hiring workers or by continuing to increase share buyback activity, says Bank of Tokyo economist Ellen Beeson Zentner. "Companies have to show their plan of how to continue profit growth, and the question is going to be asked with the first earnings reports of 2011, 'Why use cash for buybacks when you can hire? One would hope you use that cash sitting on the sidelines to hire,'" the Bank of Tokyo economist argues. If corporations have been reluctant to hire up until now, it becomes harder to justify that reluctance if the economy really is improving, especially with the tax breaks written into the tax cut package.

    The monthly nonfarm payroll report due out this Friday will be a good indicator of trading sentiment about U.S. unemployment. Last month, the number came in well below expectations; some used "disastrous" to describe the 39,000 jobs adding in November. Economists say that anywhere from 150,000 to 200,000 jobs being added monthly is the sign of a healthy labor market, yet the market shrugged off the November employment downer.

    Any significant improvement in the December number may simply add to the growing roll of improving data points about the U.S. recovery. On the other hand, a second consecutive negative surprise in nonfarm payroll and the issue of U.S. unemployment may receive new life as a trading trigger. Fortunately, most bets are for big improvement in Friday's report on December payroll additions, with consensus at 111,000 jobs being added.

    Wayne Kaufman, chief macro strategist at John Thomas Financial says that unemployment will hopefully be a non-event, with the nonfarm payroll number doing just enough to focus investors on earnings season as the worthy trigger for trading.

    "Everyone knows that 50% of S&P 500 profits come from overseas, so the picture is much bigger than the local data," Kaufman says. "Unemployment may hover here, but it doesn't mean the other 90% of people in the U.S. and the companies they work for aren't going to continue to do well," the market strategist argues.

    The Bank of Tokyo outlook for U.S. unemployment in 2011 is a rate of 8.7% by the end of the year, revised from 9.2% after the tax cut package.

    2011 Market Threat No. 5: China

    China surprised the markets on Christmas Day when it raised interest rates, but it's no surprise that the Chinese inflation issue, and fears concerning any one among a number of Chinese asset bubbles, will continue to be a closely watched harbinger of doom for the global economic recovery.

    An encouraging piece of news from China to start the new year was a slowdown in the manufacturing growth in December, the first slowdown in five months, and a sign that moves already taken by the Chinese central bank to fend off inflation may be having the intended impact.

    The Chinese central bank raised interest rates twice in the last quarter of 2010. Consumer sentiment in China and concerns about a bubble in the property sector, aligned with central bank policy to take more forceful steps to slow the rate of manufacturing expansion. China isn't expected to be done yet with its rate hike agenda as 2011 commences.

    China vs. inflation is expected to be a dominant theme next year, as it grew as an issue for traders to monitor throughout the year, and on Christmas Day, even.

    The fine line that China is walking is to avoid a property bubble and inflation, while also allowing economic expansion to continue at a reasonable pace, is a major market theme, if not an outright fear factor, for 2011.

    For the time being, the economic consensus doesn't seem to be on the side of hedge fund manager and China doomsday soothsayer Jim Chanos, but this is one 2010 debate that's ongoing and will have traders with their finger not too far from the panic button all year.

    2011 Market Threat No. 6: Federal Economic Policy

    There's no love lost between President Obama, Federal Reserve Chairman Ben Bernanke and their erstwhile foe, the free markets.

    In any given year, President Obama and Ben Bernanke need to be seen as potential villains by the markets for one reason or another. In that vein, what if QE2 and the tax cut package don't work?

    What if the federal government racks up another $858 billion in the deficit column and the economic recovery doesn't have a significant leg up in 2011?

    It may not be an odds-on bet for 2011 market-crash suspects, but it's got to at least be on the pessimist's list of questions and potential scenarios for 2011.

    While it may seem like the big issue with profligate spending by the government is moving down from the federal to state level in 2011, investors could have a short leash with the federal economic stimulus policy given the size of the deficit check written by the government to keep the economic recovery going.

    There's been plenty of evidence from past tax cuts that consumers don't always spend tax savings, especially at the more affluent end of the spectrum. Businesses haven't proven yet that they are set to ratchet up hiring in a significant way as a result of the stimulus package. Add to all of this the chance that consumers save 100% of their payroll tax savings, or use it to pay down debt, and the federal government's best laid plans to keep the economy on track could amount to nothing much in the end.

    In the words of Bank of Tokyo economist Ellen Beeson Zentner, "If there's no stimulus from the stimulus and all we do is add to ugly debt levels, investors may take issue with it. With no stimulus at all from the $858 billion, a massive flight from treasuries begins."

    2011 Market Threat No. 7: The Hindenburg Omen

    Remember back when the Hindenburg Omen signaled the death knell for the economic recovery, and a major market selloff -- if not an outright double dip recession -- was all but assured for the fall 2010?

    Turns out that the Flash Crashes of 2010 exerted a much greater corrective toll on the markets than the technical trading theory referencing the doomed German airship.

    It seemed to some at the time of the Hindenburg Omen's doomsday prediction that it was right up there with Nancy Reagan consulting psychic Jeanne Dixon to map out White House policy during the 80s -- and, in retrospect, it's a good comparison.

    Yet the failure of the Hindenburg Omen to correctly call a market correction in 2010 doesn't mean the profile of technical trading has diminished. Quite to the contrary, with the mysterious flash crashes and the notoriety of the Hindenburg Omen, it's clear that the markets are prone to quantitative, computer-driven panic.

    The run-up the market experienced to end the year, and the examples of panic based on technical trading theories and fears of high frequency trading machines that are pushing the little guy to the margins of market profit opportunities, all circle back around to the most fundamental question about equities: are they overbought or oversold as trading in 2011 begins?

    Even before the first earnings season of 2011 signals to investors the level of bullishness from the corporate sector, and with the muni bond crisis, systematic risk to Europe's financial system, Chinese inflation, U.S. unemployment, the U.S. foreclosure pipeline -- and, maybe worst of all, President Obama and Ben Bernanke still poised to be major market movers in 2011 -- it's hard to take for granted the economists' consensus bet that its onwards and upwards with the S&P 500 in 2011, without a shred of doubt.

    You don't have to take our word for it, either. The Federal Reserve Bank itself rattled off more than half this list in the minutes of its most recent Open Market Committee meeting, released on Tuesday. The Fed's decision-making body remains worried that the economy is at risk of slowing due to continued weakness in the housing markets, steep budget cuts by state and local governments, lack of pickup in hiring by corporations, and risk to the banking sector caused by the ongoing problems in Europe.

    Indeed, all this fretful talk about 2011 market crash suspects raises the unavoidable naysayer's question, What will be the Market's Greatest Threat in 2011? Take our poll below, and see what The Street is most fearful of....

    Which of the following will be most likely to cause a market crash in 2011?

    Euro Zone Systematic Financial Risk
    U.S. Municipal Bond Market
    U.S. Foreclosure Pipeline
    U.S. Unemployment
    Chinese Inflation and Asset Bubbles
    A Tax-Cut Stimulus Dud
    The Hindenburg Omen

    -- Written by Eric Rosenbaum from New York.

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