This column originally appeared on Real Money Pro at 9:40 a.m. EDT on June 25.NEW YORK ( Real Money) --
"And there will be strange signs in the sun, moon, and stars. And here on earth the nations will be in turmoil, perplexed by the roaring seas and strange tides." -- The Holy Bible, Luke 21:25 (New Living Translation)Despite the recent turmoil, the U.S. stock market is seen almost universally by strategists and investors to have limited downside risk. This unanimity of opinion should concern everyone. It sure concerns me! Given this consensus view of limited downside market risk and a general lack of fear, it seems timely to consider 10 reasons why the market might be vulnerable to a more meaningful downside. 1. U.S. economic growth slows more than consensus. Led by a pause in the housing market and a turndown in retail sales, the trajectory of domestic growth disappoints in the second half and into 2014. Most notably, the residential real estate market, which has been the straw that stirs the drink of the U.S. economy, falters under the weight of a gap in home prices (double-digit increases year over year) combined with a spirited climb in conventional mortgage rates. These two factors serve to deliver a near-30% rise in the carrying cost of the average mortgage and jeopardize the recovery in housing demand that has taken place over the past two years. Home prices reverse lower in the months ahead, owing to higher mortgage rates/lower affordability, the supply of foreclosed properties put on the market and because of the reduced involvement of new-age institutional buyers of property and homes (hedge funds, et al.). In turn, this has the effect of denting household net worth, consumer confidence, personal expenditures, GDP and ultimately corporate profits. The Fed chairman's 3% real GDP growth projection over the balance of the year misses dramatically. Real GDP grows by only +1% to +2% over the next seven quarters. The low level of actual nominal growth provides little top-line growth, a difficult challenge to profitability -- 2013 S&P profits come in at only $103 a share, and consensus projections for next year are lowered to under $100 a share. The entire notion of a self-sustaining recovery (unaided by more monetary accommodation) comes into question. Market participants come to the conclusion that the U.S. economy requires continued (but unlikely) quantitative easing. Investors come to accept that the U.S. is in some form of liquidity trap (light) with attendant negative implications for profits, dividends, share buybacks and merger and acquisition activity.
Market P/E ratios, which recently rose to over 16x a week ago (and now stands at about 15x), fall to 13x-14x in the second half of the year. 2. Japan's economic growth experiment fails. The Bank of Japan completely loses control of the long end of the curve. The 10-year Japanese government bond yields move to between 2% and 3%, a problem for a country with debt-to-GDP of over 200%. The Nikkei cracks badly, and the recent decline becomes something far more than a correction. The Japanese yen continues to strengthen even though the Bank of Japan redoubles its efforts to weaken its currency, as the hedge fund unwinding of positions accelerates. This introduces a broad-based risk-off mentality of investors, which in turn impacts risk assets in Europe and in the U.S. 3. China's economic growth rate falls far short of expectations, decelerating to 6% or less in 2013 and 2014. This negatively impacts both emerging and developed market economies. Global growth turns recessionary as dislocations in the commodity markets accelerate further. More serious bank funding problems emerge in the region. 4. The eurozone's stagnating economic condition begins to retreat back to negative growth. In particular, the French economy worsens. The eurozone collapses under the weight of ever higher funding needs or there are so many restrictions that render the current rescue ineffective. Adding insult to injury, the German Supreme Court rules that the ECB's OMT is unconstitutional. The euro continues to strengthen as the European economies erode. Sovereign bond yields retrace the recent declines, and banking problems emerge. 5. A U.S. monetary policy mistake is made. A premature withdrawal of easing by the Fed (based on too-optimistic economic forecasts) could result in significant market downside. 6. A reverse rotation out of stocks and into bonds occurs. The much-anticipated rotation out of bonds and into stocks fails to develop as a risk-averse investment community, searching for yield, is stimulated by a rise in interest rates and shuns stocks in favor of the safety of fixed income. 7. Adverse geopolitical situations develop. Areas of potential conflicts (e.g., Syria, Israel, Iran, North Korea, China, Japan) have recently multiplied. 8. The ETF market implodes and carries stocks lower. Back in my surprise list for 2012, I cautioned about the risks inherent in the structure and popularity of ETFs. I might have been correct, though 12 months early! Over the last five to 10 years, many investors (retail and institutional) have clamored into ETFs as a means of acquiring diversified, liquid and low-transaction exposure to stocks, bonds, commodities and other markets.
The ETF bubble along with the proliferation of price-sensitive and momentum-driven high-frequency-trading strategies have served to exacerbate market moves. Indeed, as I mentioned on "Fast Money" last week, nearly 70% of NYSE trading activity is ETF- and high-frequency-trading-related. I worry that the transition from accumulation to liquidation of ETF products produces tracking problems as well as transmission and redemption issues. Retail and institutional investors lose faith in the ETF system and abandon the markets. 9. It becomes apparent that control of the House of Representatives will turn over to the Democratic Party in 2014. This provides a clear mandate for the Obama administration to enact populist legislation, including a wealth tax and transaction taxes on equity and stock trading. 10. An unanticipated black swan event surfaces. As I have observed, there has been a growing frequency of black swans around the world. Black swans, by design, are something unseen.
- Perhaps it is an extreme drought in the U.S., Brazil and/or Russia, which could result in much higher commodity and food prices, adversely impacting the consumer's purchasing power.
- Maybe it is another major flash crash or a series of mini flash crashes that inject market uncertainty.
- Or a coronal mass ejection in which the sun emits solar flares that penetrate the Earth's atmosphere and initially wipe out most GPS systems and disrupt numerous communications systems, electronic devices and power grids all over the world.
- Or maybe an event that is entirely not expected such as a political coup or a liquidity event emanating from a company, sector or region not anticipated.