7 Yellow Flags to Watch For

02/28/2012 10:30 am EST

Focus: MARKETS

While we're nestled in a sweet spot right now, there are harbingers of boom and doom out there...and it's important to bear them in mind as you build out your long-term strategy, writes Bob Carlson of Retirement Watch.

I've developed seven financial and economic surprises that could happen in 2012. It's important to review not only what you think is likely to happen, but also what could happen. It's especially important to consider events and actions outside the markets-what economists call exogenous events-that could have an influence on your portfolio.

Early in the year, it's a good idea to conduct an exercise like this. Question your assumptions and outlooks. Step outside the box and consider things that could happen, but that you aren't planning on.

I think each of these events could occur, but I'm not forecasting any of them will occur, or recommending that you position your portfolio to capture expected market action from any of them. What you should take away from this exercise is there are good reasons not to position your portfolio with one economic outcome in mind.

Unexpected events could occur suddenly, and they could quickly move markets in a direction that is harmful to your portfolio. You need balance, diversification, and nimbleness to preserve capital and capture gains in today's economic world.

So, let's look at what could happen.

  • During the summer, President Obama could endorse the Bowles-Simpson Commission deficit reduction plan that was proposed last year.

The Republicans would be almost forced to accept. It would give the President the initiative and positive opinions for the rest of the campaign.

This move also most likely would generate strong optimism among investors and businesses, spurring higher equity gains and economic growth. It would likely sweep the President to re-election, and could help Democrats to large majorities in both houses of Congress.

  • Things take a more dangerous turn in the Middle East.

Iran could prove to be further along in developing nuclear weapons than expected, and be willing to use them. Or Israel might bomb parts of Iran in an attempt to disrupt the nuclear weapon-production process.

There are a number of other potential events. All likely would lead to higher oil prices, pessimism among investors, and businesses, slower economic growth, and lower stock prices.

  • Energy prices could collapse because of technology and policy changes.

Drilling in the US for oil and natural gas could accelerate, bringing down domestic prices (and probably global prices). This would have the same effect as a major tax cut or monetary stimulus. It would free up consumer cash to either be saved or spent on other items.

  • Central banks could tighten too soon.

This already has happened several times since the global economy hit bottom in 2009. Each time, the central bankers realized it quickly and reversed course before triggering a downward spiral.

The United Kingdom is the most prominent example, because it's been six months or more ahead of the rest of the world with its central-bank policies. It had a severe economic slowdown in 2011 that almost became a recession before looser money was reinstituted.

The European Central Bank actually increased interest rates in 2011, before realizing that was a mistake and reversing course quickly. Unfortunately, coupled with the latest turns of the sovereign debt crisis, the ECB didn't act fast enough to avoid a recession. In the US, there's also pressure from a number of quarters to raise interest rates.

Raising interest rates wouldn't necessarily be the same as tightening monetary policy, but it would scare some people. It would help retirees and conservative investors. Long -term, I believe the move would be beneficial, but it could depress growth for a while.

  • Too much austerity in the US and Europe triggers a downward economic spiral.

There's too much debt in the US and Europe, and a deleveraging pushes an economy toward deflation and declining economic growth.

So far, fiscal and monetary stimulus has been offsetting the deleveraging effects. But there's little appetite for additional fiscal stimulus in either region. There's also a strong sentiment toward reducing government spending and debt in the US and at least parts of Europe.

We can see the effects of too much austerity in Greece. The country is required to reduce government spending and increase taxes as part of each phase of the bailout plan. Each reduction in government spending and increase in taxes ratchets the economy down another level or two. There are no policies to trigger economic growth being discussed.

The greater the decline in economic growth, the less able the country is to pay its debts, and the more austerity that is demanded of it. The pattern is leading to a downward spiral.

The US and Europe need to reduce both private and public debts. This can be done carefully and be coupled with measures that will increase economic growth. But currently this discussion isn't on the table. The debate is between those who believe the stimulus measures to date weren't large enough and those who want to significantly slash spending.

  • Japan slides into a deeper depression, perhaps defaulting on debt.

Japan's been out of most people's line of vision for a while, but significant events are occurring. It's been mired in a depression since about 1989.

The earthquake and tsunami of early 2011 inflicted serious damage on the economy, from which the country hasn't recovered. Also in 2011, the yen climbed in value against most other currencies. That hurt Japan's exports, further hurting the economy.

Now, the Japanese economy is in serious condition. There's the potential the slide will continue.

Japan also is heavily in debt. It's been following policies very similar to those the US adopted since 2008, but Japan's been at it since the early 1990s. It's accumulated a huge pile of debt, has poor economic growth, and an aging population that's going to need more government spending in coming decades.

There is potential for Japan to default either directly or through currency debasement in the next few years.

  • The US imposes big tax hikes on dividends.

Dividend-paying stocks were the big winners of 2011. Corporations in general are flush with cash, and have been increasing the amount they pay in dividends. Companies that a few years ago wouldn't even consider dividends now have dividends in place with planned increases, or are actively considering implementing dividends.

Part of the attraction to investors is that dividends are taxed at a 15% rate. The President, however, wants to tax dividends as ordinary income, and he wants to increase the top ordinary income tax rate.

Even if that proposal doesn't become law, taxes on dividends will rise in 2013 if Congress doesn't take action. The Bush tax cuts will expire, and the previous law will be reinstated.

An increase in dividend taxes would be negative for the stock market and the economy. At a minimum, it would cause investors to sell dividend-paying stocks and buy others. They also might sell the stocks and put the money in investments other than stocks.

There's also a good argument to be made that the effects of higher taxes on dividends would decrease economic growth for at least a short period. Perhaps most importantly, an increase in the dividend tax would be harmful to retirees and conservative investors who are depending on the after-tax dividend payments-and steady increases in the dividends over time-to fund their retirement spending.

We take investment positions based on what we believe is most likely to happen. But a good investor is humble enough to realize things could turn out differently. You need to consider what else might happen, and determine in advance how you would react.

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Related Reading:

Will Crude Oil Crush This Recovery?

What's Ahead for the Economy in 2012?

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