After soaring 190% since it bottomed out in 2009, the stock market is facing major challenges that threaten to end the ride. These range from regional conflicts involving Iraq and Ukraine to a slowdown in the recovery of the US housing market.

Bottom Line/Personal asked top investment strategist Hugh Johnson to describe how the five biggest threats could end the bull market and to evaluate the likelihood that any of them will…

GLOBAL THREATS

Threat: Oil prices skyrocket over turmoil in the Middle East…and/or natural gas prices soar as Russia retaliates over US and European trade sanctions. Iraq is the second-biggest oil producer in OPEC after Saudi Arabia. It produced 3.6 million barrels a day in February and was expected to reach six million barrels a day by 2020. But as Sunni extremists gained control of major portions of northern and western Iraq, global oil prices jumped and tremors spread over possible disruptions to oil exports. Further gains by the militants could send oil prices skyrocketing to $120 per barrel or higher for the benchmark West Texas Intermediate crude (which was under $100 in January and topped $106 in June), especially if the militants were to gain control of oil-rich southern portions of Iraq and even more so if instability were to spread to other nations in the Middle East. That could translate into US gasoline prices topping $5 per gallon, driving up inflation in the US, hurting corporate profits and derailing the global economic recovery.

Meanwhile, tensions between Russia and Ukraine also have threatened world energy supplies amid speculation that Russia could cut off natural gas exports to countries in much of the ­European Union, which rely on Russia for 30% of their natural gas needs. Under that scenario, natural gas prices could double, derailing Europe’s fragile economic recovery as well as the earnings of many large US corporations, which were counting on stronger ­European growth to boost profits.

My take: These regional conflicts represent my second-biggest fear among the five major threats to the stock market but also are the most difficult wild cards to gauge. On the surface, the conflicts seem containable, more of a political threat than an economic one. Although short-term disruptions in global oil supplies could impact the US and other economies, the warring parties in Iraq realize that oil exports are the country’s lifeblood and necessary to be able to rule effectively no matter which side prevails. Also, Iraq contributes only about 4% to global oil production overall. Even if that production falls or fails to increase in the future, it won’t disrupt world energy markets longer term because Saudi Arabia could quickly ratchet up its oil output and US oil production is rising rapidly. The crisis over Ukraine also seems containable. I believe Russian president Vladimir Putin is unlikely to cut off natural gas sales to Europe because the loss of revenue would seriously weaken Russia’s economy.

Likelihood that one of the regional conflicts ends the bull market: Medium.

Threat: China’s economy melts down. China has been trying to stem a slowdown in its economic growth after decades of double-digit annual percentage gains. The second-largest economy in the world has become so integral to world trade that even a dip in its annual growth to 6% from the recent 7.4% could severely hurt countries with economies that rely on exporting raw materials and goods to China. These include Australia, Brazil and various European nations. The slow-growing US economy is not strong enough to shrug off the drag of a global recession. Multinational corporations would be especially hard hit.

My take: Although China’s economic growth rate may fall short of 7.5% for 2014 and 2015, I believe it’s unlikely that it will drop below 7% and drastically affect other economies. Remember, a large part of this slowdown is due to specific actions that the Chinese government has taken—and can modify—as it tries to shift from an economy driven by investments and exports to one that benefits more from increased spending by Chinese consumers.

Likelihood that slowing Chinese economic growth ends the bull market: Medium to low.

US THREATS

Threat: Interest rates soar. As the Federal Reserve continues to unwind the bond-buying program that has helped bolster the US economy, the yield on 10-year US Treasury notes could increase from the recent 2.5% to nearly 3.5% by the end of this year and nearly 4% in 2015. Those levels are high enough to kill investor enthusiasm for stocks. In addition, we could be close to the tipping point where lower unemployment rates and higher ­inflation levels force the Fed to increase short-term interest rates for the first time since 2006. The end of cheap ­financing would make it more costly for consumers to pay off credit card debt or draw on home-equity lines of credit to redo a kitchen. Higher interest rates also would cut into corporate profits. As a result, consumers and corporations could cut back on spending, putting the brakes on economic growth.

My take: This is my ­number-one fear. Reason: It’s the only one of the five major threats that is nearly inevitable. Over the next 18 months, interest rates are likely to continue to go up. A slow, measured rise would be less painful for stocks than a sudden one, but either way, if rates rise far enough and long enough, that could end the bull market.

Likelihood that rising interest rates will end the bull market: High.

Threat: The stock market “melts up.” The possibility of an unexpected jump in US economic growth could ignite a major stock market rally this year and next that could push the S&P 500 to 2,300 from its recent level below 2,000. Investors sitting on the sidelines could “panic” about missing out and decide to jump in as the market reaches dizzying heights. The Federal Reserve wouldn’t take immediate action because it is more focused on inflation and unemployment figures than on stock returns. That could help propel stock prices to become bubblelike, or “speculative,” because corporate earnings growth couldn’t keep pace. This could lead to another shocking market crash as the Fed raises interest rates to take the air out of the bubble and investors realize that stocks have become overpriced.

My take: A rally that produces high double-digit returns for the stock market this year and next is unlikely. Investors, who still remember the 2008 crash, are too aware of the dangers ahead.

But I would not rule out this scenario if investors become overly optimistic.

Likelihood that a melt-up could end the bull market: Medium.

Threat: The housing recovery fizzles. This could happen if fixed rates for 30-year mortgages top 5% by early next year…prices rise another 10%…and the inventory of homes for sale shrinks as home owners who locked in lower mortgage rates are reluctant to move. Home sales might rise by just 5% this year and remain flat next year. All that adds up to a sputtering housing market, hurting not just real estate stocks but also the entire stock market because spending on homes is a major driver of US economic growth.

My take: The strongest part of the recovery in housing is mostly behind us. Even so, I think gains still can continue at a very modest pace. Rising employment and loosened credit conditions mean that more buyers will qualify for loans. As long as mortgage rates stay below 6%, sales should continue to rise.

Likelihood that a halt to the housing recovery ends the bull market: Low.

Expect 5%-to-6% Stock Gains

If none of the threats discussed in the main article materialize in full force, I think the bull market can continue for the next year or two, although it won’t be very exciting. Stocks have risen for more than five years because corporate profits have been strong. Companies have reduced costs, including interest levels on their long-term debt. As a result, investors were willing to bid up beaten-down share prices amid expectations of a stronger economy.

With stocks fairly valued now and cost reductions more difficult for companies to achieve, we will need to see solid corporate earnings growth for the market to advance. Because I expect annual profits to grow in the 5%-to-6% range over the next few years, that’s how much I think stocks are likely to rise. I still am recommending that investors overweight stocks relative to bonds because returns from stocks, although modest, will still likely be higher than from bonds.

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