Complacency Conceals Risks

01/26/2007 12:00 am EST


James Stack

President, Stack Financial Management

James Stack, the veteran contrarian editor of InvesTech Research, warns that investors are taking the good times for granted and the US market could be in for some nasty surprises in 2007. Japan may be another story, however....

"If complacency breeds danger, then we might be sitting on a powder keg heading into 2007.

"This is the fifth longest bull market in the past 75 years, and the second longest period in the history of the Standard & Poor's 500 without a 10% correction. And it is now the longest period in over 107 years without a 2% intraday decline in the Dow Jones Industrial Average.

"It seems the party is in full swing and the punch bowl is overflowing. But imagine the mayhem if something should trigger a panic run for the exits. What might trigger such a run for the door? With speculative hedge fund managers dominating the show, it could be just about anything. However, our bet is that it will be one of three factors:

1. A surprise return to tightening by the Federal Reserve if the economy starts to accelerate. Fed governors continue to express inflation concerns, and both the European Central Bank and the UK are likely to continue raising interest rates in 2007, largely in response to concerns about the inflationary impact of upcoming wage negotiations and continued growth in their domestic economies.

2. An unexpected plunge in the US dollar as foreign investors pull out of the greenback in search of more competitive rates overseas. Sudden currency market adjustments, if they occur, could reduce global liquidity. While foreign central banks support a gradual adjustment, they may be powerless to respond to volatility.

3. The housing sector drags the US economy into an unavoidable recession. In the past 40 years, private residential construction has never contracted to this extent without triggering a recession. "Those are not the kind of investment odds we like to write home about. And they're one reason we've been willing to leave some good profits on the table during the past year with our moderately defensive stance. (Our mild underperformance in 2006 was offset by our stellar outperformance in 2004-05.)

"With these risks in mind, we continue to believe that Japan will be one of the most undervalued and safest opportunities for global market returns in 2007. Continued growth in Asian economies will likely offer potential among these emerging markets and provide a degree of stability for Japan. Also, a hike in Japanese interest rates should not get in the way of improved economic growth and could provide added benefit in the form of a stronger yen."

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