4 risks that could cut the market in half

Depending on how these potential pitfalls break, stocks could go way up or way down.

By Ken Kam Jan 4, 2010 10:26PM

At the moment I see four risk factors that could cut the market in half or cause it to soar.

 

We're watching for clients as we adjust their investment strategies for the new year.

 

If they break the wrong way, they won't just bring one or two companies down. They have the potential to bring the entire stock market down. At the same time, however, if these risks recede, the entire market could soar. 

Unfortunately, investors cannot stay out of the market until these risks are resolved because by then the market will have already moved one way or the other. In order to make money, we have to make some difficult judgment calls. To read about the judgment calls we are making for our clients right now click here to download a PDF of our year-end report titled "What Should Investors Do Now?"

Here are the top four market risk factors we see right now.

1) Tight monetary policy. To prevent the world's financial system from becoming insolvent, the Federal Reserve, in coordination other central banks, pumped large amounts of money into the world's economies to provide liquidity. Now that the banks have been stabilized, the central banks are going to have to remove the extra cash from the system. If they remove it too quickly, they could cause the economy to relapse into recession. If they remove it too slowly, they could create an unsustainable inflationary boom. It is not going to be easy for the Fed and other central banks to withdraw the extra cash at just the right pace to keep the economy expanding without setting up another cycle of boom and bust.

2) Reduced U.S. government debt capacity. U.S. Government debt has always been regarded as "riskless", and it has always carried the highest rating. The "full faith and credit of the United States" is at the core of everything. Without guarantees provided by Fannie Mae, Freddie Mac, or Ginnie Mae, there would be no market for securitized mortgages at this time. Even the Federal Reserve would look shaky if the 40% of their balance sheet that is invested in mortgage backed securities did not have a government guarantee. But the amount of borrowing that the government needs to do -- on the order of $5 trillion over the next 3 years -- is staggering. I don't know how much the government can borrow before people start to doubt the full faith and credit of the United States, but I am afraid we may find out.

3) Globalization triggers a trade war. One of our country's core long-term problems is that there are billions of people in other countries who aspire to a western middle-class lifestyle, and they are willing to work hard for pay that we consider to be slave-wages. Allowing countries with such low pay scales to sell their products in our country gives American consumers incredibly cheap goods that American producers cannot compete against at American pay scales. As a result, American producers have had to move manufacturing jobs to countries with low pay scales in order to be competitive. If demand picks up, American producers will likely scale up production in low-wage countries instead of in the U.S. putting political pressure on the U.S. government to adopt protectionist policies that could trigger a trade war.

4) Insolvency of the financial system. The basic problem at the heart of the financial crisis is that banks made trillions of dollars worth of loans collateralized by real estate that is now worth less than the loan. At the beginning of the 2009, these loans were being bought and sold for between 20 cents and 40 cents on the dollar. If banks had to value these loans at what they could sell them for, many would be insolvent. To prevent the widespread closure of banks, regulators changed the rules to allow banks to value most of these loans at cost instead of market value. Under the new rules, if a bank intends to hold a mortgage to maturity, they can value these loans at 100 cents on the dollar instead of 20 to 40. This makes the banking system appear solvent and perhaps even "well-capitalized." As long as borrowers keep making their payments, there is hope that one day the loan will be paid off in full so there is some justification to carrying the loans at full value. However, when borrowers stop making payments, there is no hope that the bank will ever be repaid in full and the loans have to be written down. It is estimated that 25% of all mortgages are underwater -- meaning that the loan amount is greater than the market value of the property. If the borrowers who are underwater stopped making payments on their loans, and the banks had to write down the value of these mortgages, we could quickly be back to looking at an insolvent financial system.

Protect yourself

The S&P 500 has crashed TWICE in the last decade, losing 49% and 56%. These risk factors are the ones we think are big enough to cause another crash.

We all want to get our financial plans back on track, but for many people, suffering another 50% crash would set them back so far that they could never recover. For this reason, we think most investors need to give as much weight to protection of capital as to performance.

For more of our thinking about how to pursue both performance and protection at the same time, download our year-end report by clicking here.

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