3 Big Risks That Could Derail the Rally

03/27/2012 8:00 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

Don’t worry too much about natural pullbacks like the one we saw last week. Worry instead about game-changing events that could change the trend, writes MoneyShow’s Jim Jubak, also of Jubak’s Picks.

Last week, the S&P 500 suffered its biggest drop since December. The index’s 0.5% decline for the week wasn’t huge, but it stands out in the context of a market that has been up in ten of 11 weeks in 2012.

The Dow Jones Industrial Average fell more on the week, 1.2%, after reaching its highest level since December 2007 on March 15. The Dow Jones Transportation Index, which reacts strongly to sentiment on the US economy, lost 2.5%. That’s the biggest drop in that index since November 25.

I don’t want to make too much of a one-week decline. You get them in every rally, and a 0.5% or 1.2% pullback isn’t much, considering how far we’ve come in 2012. Even after the drop last week, as of March 23, the S&P was up 11.09% for 2012.

And certainly, the news behind the drop was terribly familiar. Economic indexes in China and Europe showed evidence growth was slowing. Oil prices stayed elevated at just north of $125 a barrel for benchmark Brent crude. Yields on Spanish debt climbed. Nothing really new.

But I don’t think we should automatically dismiss this as a routine decline on familiar news. That’s because, like many other dynamic systems, the financial markets aren’t totally linear. At some point the markets can turn steady and not terribly large moves into a bigger change. Those nonlinearities of the market worry me—and, I think, many investors—right now.

I can see three scenarios that might at some point turn a series of small, incremental changes into a much bigger move—one that is different in kind and not just business as usual for a rally with its typical corrections.

I’m not saying that any of these scenarios is sure to occur, but that all loom as possibilities on the not-too-distant horizon, and you ought to figure that risk into your strategy for investing.

The Oil Risk
Take the rising price of oil, my first nonlinear scenario.

The consensus among Wall Street economists is that while rising oil prices will cut into economic growth, the damage to growth is modest—as long as the increase in the price of oil is gradual, and the overall increase isn’t too dramatic.

For example, Goldman Sachs projects that a 10% increase in the price of oil would cut 0.25 to 0.5 percentage points off US economic growth. With growth for 2012 forecast at 2% to 2.5%, a decline in growth of that dimension—which would take US growth to anywhere from 1.5% to 2.25%—wouldn’t help the economy or stock market, but it wouldn’t be a disaster, either.

But scale up the rise in the price of oil to the kind of jump we might see from an attempt by Iran to close the Strait of Hormuz to oil traffic, and the disruption jumps in seriousness.

A disruption to oil flowing through that area would, according to IHS Global Insight, take 1.5 percentage points off economic growth in the Eurozone, the part of the global economy most dependent on imported oil.

That could turn what is predicted to be a mild recession in the first half of 2012 into a deep recession in the Eurozone. And that could send Spain and Italy into crisis.

The Spain Risk
That is, you should have guessed, my second nonlinear scenario. I think Spain is the likely locus of any new crisis.

Right now, we’re witnessing a slow but steady increase in the yield on Spanish ten-year bonds. Yields climbed by 0.19 percentage points last week, to close on Friday at 5.37%.

That’s still a long way from the yields north of 7% that Spain saw in the most recent round of the Greek crisis. But yields, which rise with perceived risk, are definitely headed in the wrong direction.

At the beginning of March, Spain told the Eurozone countries that it would miss its budget deficit target of 4.4% for 2012 by a huge margin. The deficit, said Prime Minister Mariano Rajoy, would be 5.8% of the gross domestic product.

The announcement took European leaders aback, especially when Rajoy presented resetting the deficit target as a "sovereign decision" by Spain. After a little horse-trading, everyone agreed on a budget target of 5.3% in the budget to be announced by Spain on March 30.

For 2013, Spain remains committed to reducing the deficit to 3% of GDP. But that’s going to be difficult if the Spanish economy continues to shrink at something like the 0.3% contraction in the fourth quarter of 2011. The International Monetary Fund forecasts that it will, projecting that the Spanish economy will contract by 1.7%.

But it’s going to be just about impossible if oil prices spike, cutting an additional 1.5 percentage points off growth. Remember, this is a country with 23% unemployment.

A Spanish debt crisis wouldn’t be like a Greek debt crisis. Spain’s current government debt is a relatively low 66% of GDP. But private debt stands at a huge 220% of GDP.

An austerity program that slowed the Spanish economy even further and made it harder for the Spanish private sector to carry its debt would push the country toward some kind of public assumption of private debt. (A version of Ireland’s bank bailout, perhaps? That’s a cheery thought.)

That’s already happened to a degree, as the Spanish government has stepped in with public money to support the merger, acquisition or liquidation of the weakest of its caja, or savings, banks. But if the economy continues to shrink, I think that process will accelerate.

That, of course, would push the Spanish government deeper into a hole…just as Eurozone countries are signing up for an agreement on fiscal discipline that would set even tighter limits on budget deficits.

Spain worries Eurozone leaders enough that they’re looking for a way to increase the current €500 billion ($666 billion) limit on the European Stability Mechanism, the permanent bailout fund set to go into operation this year. That fund will replace the current European Financial Stability Facility.

But while unused funds from the facility would move over to the mechanism, the permanent fund would still have the same €500 billion limit under current rules. (Got that?)

When finance ministers meet, starting on March 30, they’re expected to look for a way to have the two funds operate in tandem so the unused funds from the Financial Stability Facility can add to the €500 billion limit. That would bring the total bailout funds available to €692 billion, roughly $923 billion.

That might be enough to convince the markets that Spain is not in jeopardy. In that case, the fund would never need to be used—that’s the hope, anyway. Since if Spain needs a bailout, then Italy moves to the front of the line, and even the bolstered facility isn’t enough to cover both contingencies.

NEXT: The China Risk

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The China Risk
My third nonlinear scenario is set halfway across the globe, in China.

On March 22, the Agricultural Bank of China, China’s largest rural lender by assets, announced a 29% increase in profits for 2011.

Taking a bit of the shine off that good news was the bank’s report that it would set aside about $9.3 billion to cover a potential increase in bad loans. That was a 48% increase from what the bank set aside to cover potential bad loans in 2010.

Investors were entitled to a certain confusion at the announcement, since the bank announced at the same time that its nonperforming loan ratio had declined to 1.55% in 2011, from 2.03% in 2010. But confused investors must have missed the memo.

Last month, the China Banking Regulatory Commission told lenders that it had misclassified about 20% of its outstanding loans to local governments. Banks had placed such loans in their safest category, declaring that the loans were fully covered by cash flows from the local government projects. That wasn’t exactly the case for what amounted to 1.8 trillion yuan ($286 billion) in loans.

When, and if, banks reclassify the loans, they will have to set aside more money for potential loan losses (as the Agricultural Bank of China did) and ask local governments for more collateral. Moody’s Investors Service estimates that 20% to 33% of these loans will go sour unless the government steps in.

If you’ve been wondering why everybody is so afraid of a hard landing in China, you’re looking at the answer. If China’s economy slows to 7% instead of the 7.5% growth target set by Beijing for 2012, it won’t be a big deal in terms of jobs or company profits (especially company profits at state-owned enterprises). But it will be a big deal for all these local government-related loans—whether direct loans, loans through the 6,000-some government-affiliated financial companies, or loans to local companies.

Local governments don’t have a steady stream of tax revenue anywhere near big enough to cover the payments on these loans if projects go bad and if the local real-estate market stops generating substantial revenue from land sales.

A hard landing for China’s economy wouldn’t cause just an incremental increase in pain for local governments, affiliated financial companies and the banks that lend them money—it could well create a need for Beijing to bail out China’s biggest banks and bury their bad loans again.

What to Watch
OK, those are my three candidates for really bad things that could happen if oil prices rise higher and faster than expected, if European economies slip into a deep recession, or the Chinese economy slows.

The question is, as always, what do you do about those possibilities? You, of course, watch to see how they develop.

Investors will be able to track the direction and speed of oil prices without much difficulty. The European Central Bank, the International Monetary Fund and the Organisation for Economic Co-operation and Development all publish forecasts on European economies.

Data—well, trustworthy data, anyway—on China’s economy and banking system are harder to come by. But the Chinese government, China’s banks, and the big credit-rating companies, such as Moody’s and Fitch Ratings, provide a decent window into the health of the Chinese economy.

I think there’s also a strong argument for watching from the sidelines. We’ll know a lot more about oil supplies (and disruptions) from Iran, Syria, Libya, and the Sudan in a few months.

By June or so, we’ll have a better read on whether the Eurozone is about to relive the Greek debt crisis and on whether efforts to steady the Spanish and Italian economies are bearing fruit. In roughly that same time period, we’ll have a much better sense of how strongly the Chinese government, including the People’s Bank of China, intends to move to buttress growth and the banking system.

There is, in other words, a strong argument for moving some portion of your portfolio to the sidelines for a few months.

Your decision ultimately will depend on your read on how likely any of my three scenarios are to come about. In my opinion, they aren’t exactly the kind of low-frequency events (no black swans here) that it’s safe to ignore until they bite you. They’re actually more likely than, say, the US mortgage crisis or the collapse of Lehman Brothers were (though they would be much less devastating to the financial markets).

I’m not looking for a replay of the 2008 meltdown. But I wouldn’t be surprised to see a replay of some of the worst downside volatility of 2011 if any of these scenarios comes about.

The danger of moving to the sidelines is, of course, that you’ll miss any further move up in the markets—especially the US stock market—if none of these scenarios plays out, and if, instead, the US economy is stronger than expected in the first half of 2012.

The way to make the most money in the stock market is, as always, to take big directional bets—and to get them right. That’s also a reliable formula for how to lose the most money, if you get the directional bet wrong.

I don’t see the odds favoring bets that this market will dodge all these scenarios—as well as the incremental negatives, such as rising oil prices and slowing growth in Europe and in China.

I’m going to play it cautious. I’ll look for stocks with dividends, growth stocks selling at reasonable prices, and value stocks that are selling at really good prices and are headed for a turnaround.

I think the best advice is to try not to force anything. If the market gives you a genuine opportunity, take it. But realize that the odds are that you’ll see an expanding number of opportunities over the next few months.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Polypore International as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio here.

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