What Could Possibly Go Wrong?

08/25/2009 12:00 am EST

Focus: MARKETS

James Stack

President, Stack Financial Management

James Stack of InvesTech Research remains a bull, despite the long-term threat of inflation and rate hikes.

Our comfort level with the “unloved” bull remains firm. But even though the S&P 500 is up [more than 50%] since the March 9 low, now is not the time to become complacent with such a healthy gain. In fact, we’ve started to look ahead 12-18 months down the road and ask ourselves: what could go wrong to cut this bull market short?

With the massive injection of liquidity into world economies, we are concerned that some bubbles are starting to re-inflate. In this regard, China stands out as an example. On a comparative basis, the size of China’s economic stimulus package as a percentage of GDP is nearly 2.5 times as large as in the US. And economic growth was up 7.9% in the second quarter, compared to a year earlier. In contrast to the United States where credit has been tight, bank loans in China are readily available and officials have encouraged lending to help the stimulus plan take hold. The economic results are obvious and beneficial [as evidenced by headlines indicating rapid growth.] However, all this is a little worrisome since dangerous bubbles appear to be forming.

Since the low in November 2008, the Shanghai Composite Index has pushed up 103%. With this explosive move, the index became the second largest stock exchange in the world! In addition, China’s economy is now the third largest, behind the United States and Japan. On top of all this, real estate markets are buzzing and the value of property sales is now up 60% through July 2009.

While these developing bubbles are not an imminent danger for the US economy, we see this as a possible warning flag to keep an eye on going forward.

Although inflation is currently tame, we’re starting to see a reversal in inflationary pressures as expectations of a global recovery have moved commodity prices higher. After coming off a record low, the rate of change in the CRB Spot Commodity Price Index is rebounding rapidly. This index tracks the price of 13 raw industrial materials—excluding food and energy. Hence, there is a broad risk that inflationary psychology could reappear as the recovery unfolds. To a degree we are already seeing this now. The Institute for Supply Management is reporting that the number of purchasing managers paying higher prices has bounced back up to normal levels.

Over the last two years, a combination of factors caused a temporary improvement in the US trade deficit. These factors included a sharp drop in imports as the recession took hold, and more recently the big drop in oil prices from $145 to under $50. Another factor contributing to the firmer dollar has been its traditional “safe-haven” status during times of crisis.

If all of these contributing factors dissipate or reverse in 2010, then the US dollar could be headed for trouble. The danger of a weaker US dollar could accelerate the return to a tighter monetary policy, and nothing kills a bull market faster than rapidly rising interest rates. Just another concern to keep our eye on down the road.

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