Stock prices have doubled over the past three years, but now several potential crises threaten to deflate the bull market. Although it is difficult to predict which, if any, will come to pass, each could have far-reaching consequences for investors. To gauge the impact if any one of them occurs, Bottom Line/Personal spoke with top market analyst Hugh Johnson. His take on six threatening scenarios…
Scenario: Taxes jump. Unless Congress acts, the Bush-era tax cuts from a decade ago are due to expire on December 31, 2012, pushing up federal taxes for just about everyone and, as a result, causing consumers to cut back on spending. Also, Social Security payroll tax cuts are due to expire. And automatic government spending cuts are due to start taking effect in January under the Budget Control Act. Congress is likely to remain politically gridlocked until after this year’s November elections and possibly into the lame-duck session that follows. As a result, fears could mount that the US economy will fall back into recession. Markets could crash in a “Black December” as panicked investors rush to take profits before the new year and avoid the effect of higher taxes on capital gains, dividends and income.
My take: This is my number-one fear because it is not clear what will block this scenario. If it happens, it could tip us into a recession and doom the bull market.
Likelihood: High.
Scenario: Corporate profit gains halt. After a string of eight consecutive quarters of double-digit profit gains for companies in the Standard & Poor’s 500 stock index, earnings growth could plunge in 2012.
My take: Earnings gains are slowing, not collapsing. That’s perfectly normal by the fourth year of an economic recovery and not enough to short-circuit the bull market. Earnings growth for the S&P 500 was 7% in the fourth quarter of 2011. I expect single-digit gains for the rest of this year and into 2013.
Likelihood: Medium.
Scenario: Apple plummets. Apple has the biggest total stock market value of any company and is one of the most widely held stocks. If any quarterly earnings fall way short of estimates, Apple stock could plummet by as much as 40%. Given Apple’s domination of the stock market—its 50% gain in the first quarter of 2012 accounted for 15% of the entire S&P 500’s gain, and about one-third of all US mutual funds own Apple shares—many investors could suffer. More serious would be the detrimental effect on investor psychology.
My take: Apple can continue to maintain strong earnings growth for years. But even if profits slow, the likelihood of the stock suddenly losing enormous value is remote.
Likelihood: Low.
Scenario: Oil prices soar. Under this scenario, Israel or the US bombs Iran’s nuclear sites. Then Iran closes the Strait of Hormuz to oil-tanker traffic by laying mines in the six-mile-wide passage, effectively cutting off 20% of the global oil supply at least temporarily. Crude oil prices double, briefly topping $200 per barrel and sending gas prices in the US north of $6 per gallon.
My take: This is one of my bigger worries because global oil supplies are already tight, which means that a crisis could cause prices to soar. The stock market can handle an oil increase of up to $120 per barrel (compared with the recent $103) for several months, but anything higher probably would tip the US into a recession and end the bull market.
Likelihood: Medium.
Scenario: China’s economic growth slows drastically. After economic growth of 9% to 14% annually over the past five years, China, the world’s second-largest economy and largest consumer of raw materials such as iron ore and agricultural products, could stumble as it tries to fight inflation. Its economic growth could drop below 7%. If it falls this drastically, demand for global resources could sink, hurting a variety of companies around the world.
My take: A hard landing is not in the cards for China’s economy. China’s inflation is easing, and the message from global financial markets is that Beijing will be able to produce slower but more sustainable growth in the 7.5%-to-8% range over the next several years.
Likelihood: Medium to low.
Scenario: European countries default. Even though Greece’s debt crisis has been put on hold temporarily, other, bigger European nations, such as Spain and Italy, still face major economic woes as their cost of borrowing jumps and much of Europe faces a recession. For instance, Spain—the euro zone’s fourth-biggest economy and among the weakest—could suspend interest payments on its debt. As a result, several international banks, holding billions of dollars in nearly worthless Spanish government bonds, would have to seek bankruptcy protection as the financial contagion spreads. Markets would suffer double-digit losses.
My take: A Spanish or Italian default was the biggest wild card that I feared would end the US bull market in 2011. But the likelihood has receded greatly.
Likelihood: Medium.
While all of these potential crises are daunting, I believe that this aging bull still has some charge left. Even if stocks pull back temporarily in the next few months (as they did in April), I expect market returns still will crawl higher by the end of this year and in 2013. I’m maintaining a bullish long-term allocation in my portfolio—about 60% stocks/40% bonds—because stocks still look more attractive than bonds…and because the global economic outlook is continuing to improve. At the same time, the pace of stock market gains will become slower and more uneven.
