What could go wrong

Further to my last post indicating that the bulls are firmly in control of the stock market, I received a number of comments to the effect of "what are risks in your forecast?"


Bullish call for traders only
First of all, I would emphasize that my bullish call is for traders only. Investors should be cognizant of the macro risks inherent in this market. I agree with John Hussman that central bank action is only propping up a house of cards and the macro risks are considerable [my emphasis]:

I continue to view Bernanke's apparent objective for QE2 - to create a "wealth effect" by encouraging speculation in risk assets - to be dangerously misguided. Historically, the elasticity of GDP to changes in the stock market is on the order of 0.03 to 0.05, and is transitory at that. In plain English, this means that even large changes in the value of the stock market do not translate well into changes in GDP. This is because consumers correctly consume on the basis of what they see as their "permanent income," and are well aware that changes in volatile assets tend to be transitory when they are not accompanied by growth in real output and incomes. Bernanke is not thinking as an economist in this regard. He is thinking like a witch doctor calling on animal spirits (ooh, eee, ooh-aah-aah, ting, tang, walla-walla bing-bang).

And the ECB seems to be getting into the act as well:

Finally, last week, Jean Claude Trichet, the head of the European Central Bank, provided early indications that the ECB would be stepping up its buying peripheral government debt issued by Ireland, Greece, Portugal and Spain. Of course, the ECB prefers to "sterilize" these interventions, so it can be expected to sell the debt of stronger members such as Germany. Accordingly, yields dropped on the debt of credit-strained European countries, while German yields pushed to fresh yearly highs.

It doesn't take much thought to recognize that, like Bernanke's actions, the actions of the ECB are ultimately likely to represent not monetary policy but fiscal policy. When you buy the debt of countries that have a high likelihood of defaulting on this debt, or will avoid default only by the creation of currency that could have been issued to finance fiscal expenditures, it follows that you are engaging in fiscal policy without the authorization of elected governments.

For the time being, my inner trader continues to believe that central bankers are intent on throwing a huge party - so enjoy it while you can (but don't forget to keep an eye on the exit).


Keep an eye on China
While the risks posed by the actions of the Federal Reserve and the ECB are longer term in nature, the biggest risk to the near term outlook continues to be China.

The Chinese economy may be slowing. Indicators such as the Baltic Dry Index are suggestive of incipient weakness. The Chinese have indicated that they are worried about inflation and  they may take further stepss to tighten monetary policy by increasing banking reserve ratios in 2011. Other analysts have indicated that the Chinese authorities may resort to interest rate increase and possibly price controls.

I believe that as long as the RMB-USD peg remains, Federal Reserve actions (QE2, QE3...) are likely to export asset price inflation to China and the Chinese authorities have limited tools available to combat domestic inflationary pressures. The real risk becomes one of China going overboard on the limited toolset that they have and send their economy into a hard landing.
 
Moreover, with the US recovery continuing to be anemic for the forseeable future and the 2012 presidential election just over the horizon next year, trade tensions with China are likely to rise in 2011 because of domestic political considerations.
 
What happens if either Washington or Beijing miscalculates?


Watch for signs of weakness
For the time being, I am watching the Shanghai market closely. The chart below shows that while that market has retreated from recent highs, it appears to be only corrective action (for now). Should the Shanghai Composite weaken further, along with other indicators such as the Baltic Dry and more signs of Chinese tightening, then it's time for the bulls to head for the exits.