The Next Shoe to Drop - Part II

July 18, 2014

Welcome back, dear readers. As temperatures (and the stock market) continue to rise, it’s time for Part II of our two-part summer beach read about potential causes of the next market drop (click here for part I).

Just to recap, we’re rating potential causes of the next market slide on a scale from 1 – 10, with 1 being very unlikely to cause the next fall, and 10 being almost certain to cause the next fall.

Rising Interest Rates – 3

All asset roads lead to rates, and even the rates in Rome are low these days.  If rates climb significantly, the whole house of cards may come down – real estate, stocks, the global economy.  As we near the end (or not, in some countries) of historical global Central Bank policy to re-expand economies, we’re finding interest rates are falling, not rising as previously predicted by the experts.  It’s entirely possible we’ve hit a permanently low plateau in interest rates.  It’s a good thing, sort of.  We can’t handle significantly higher rates at the moment.

Falling Dollar – 1

American declinists lose.  While America has plenty of problems, in order for our dollar to collapse (as predicted by countless doom-and-gloomers since the last recession,) other countries would have to do better than us.  Any prediction that puts America at the bottom of the economic heap for an extended period of time is probably not going to come true.

Deflation – 7

European Central banks just set the interest rate gun on negative.  If you deposit $100 with the Central Bank, you’ll get less than $100 back later. Even your mattress now offers a better rate — zero. Fortunately for global credit creation, mattresses don’t come big enough to stuff billions of dollars under (although Sealy is trying – have you seen the $3,000 Optimum Gold?)

This is all to create rising prices, no matter what, because the only thing worse than prices rising fast is falling prices – which doesn’t sound half bad until you think about it. Imagine trying to get a loan to buy a $300,000 condo if you expected prices to fall 5% a year for the next three decades. Your loan would always be underwater. And how would you afford the payments when your wages drop? And why bother owning at all, since rents will decline each year? Sometimes, we put off buying a car because next year’s may be better, but imagine if next year’s was better AND cheaper?

Inflation – 2

The only danger here is that we’re so successful fighting deflation that we cause inflation of more than 2% a year. This seems even less likely than it did a few years ago. Asset price inflation is more of a concern than price inflation. The main problem here is that central banks don’t have an easy way to inflate wages and prices without sending asset prices up much faster and creating other problems. This could be because their primary mechanism is in the bond market buying bonds and creating new money. Maybe if they just created new money in people’s bank accounts and skipped the bond market…

Recession – 4

The global economy is a little shaky, and our own GDP was just weak – hopefully the result of bad weather this past winter. But recessions may be back as a more normal and frequent part of the business cycle. Our biggest fear here is that we’re still in low rate/monetary stimulus mode from the last recession. It may scare investors if we have no room to do anything else. Better to raise short-term rates a bit so at least we can all relax and expect the next round of rate cuts to save us.

Collapse of China – 4

While the economy in this global growth engine may finally be seeing the limitations of central planning, the stock market has already underperformed in recent years. If we don’t get an economic crash in China, the stock market should do well from here. Even with an economic crash, Chinese stocks may do no worse than any other emerging market. 

Collapse of the Euro – 2

The great collapse of the euro brought on by “loser” countries like Italy and Greece seemed so likely a few short years ago. Nowadays, Italy can borrow at interest rates not far off from the good ole’ U.S. of A. If Europe goes down, it won’t be because of the debts of poorly-run countries. It will be due to overall economic stagnation and deflation. 

Valuations – 7

High stock prices by themselves can lead to trouble. Although many stocks are expensive, they’re not all historically expensive, so as  long as rates remain low, we should avoid major trouble. Still, this is about our biggest risk going forward, particularly how it relates to future growth rates. Part of the relative cheapness of many stocks may just be that more companies are growing slowly and have to be priced as value stocks.

Growth Problems and a Permanently Low Trajectory - 9

Internet advertising revenue growth may mature and take down the valuations of the entire ecosystem of Internet-related companies living off of this expected revenue growth. This is not as dire as having no revenue model like in years past, but can be a major negative to prices. Worse, the economy (globally and in the U.S.) may just not be able to grow at past long-term rates anymore. 

Maybe people get lazy. Maybe we’ve just reached the limitations of fast productivity growth. Ultimately, stock prices can’t grow fast with low economic and earnings growth. In all, this overall slow growth is an amazing amount of profit-shifting in which the Amazons of the world destroy the Radio Shacks.

Well, there you have it. Our best odds on what will be the Great Unwinding. None of these seem particularly likely to unfold like a Greek tragedy in the next year (especially since the Greek economy is no longer on death watch,) so enjoy the rest of your summer!