Beware of Potential Black Swans

 | Feb 06, 2012 | 11:30 AM EST
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What a difference six months makes. In early August, I was fielding calls from my clients convinced that their retirement savings were headed down a sinkhole due to a September-2008 style meltdown. The market Cassandras were out in full force predicting a double-dip recession in the U.S.

Fast forward six months, and the mood has now changed to cautious optimism. The U.S. stock market has embarked upon a slow and steady run upward since the new year. The Market Volatility Index (VIX) has tumbled below 20. Fear is slowly transforming into greed.

As Harvard economist John Kenneth Galbraith observed: "The financial memory is very short."

And there are some good reasons for this. The economic data in the U.S. continue to surprise on the upside. Even as the International Monetary Fund (IMF) ratcheted down estimates of global growth in January, the U.S. economy may grow as much 3% this year. Of course, what drove Friday's market rally was the news that the U.S. economy added 243,000 jobs in January, driving the unemployment rate down to 8.3%.

But investor sentiment in Europe is improving as well. The cost of insuring 10 million pounds ($15.8 million) of European investment-grade corporate credit for five years has fallen by more than 70% since the start of the year. And that's a hardly two months after a noted columnist in London Financial Times gravely declared that "the eurozone had 10 days to live."

Skeptics will point out that the market is on yet another artificially induced sugar high. After all, in the U.S., the Fed's government bond-buying program has pumped $600 billion in new money into the economy. And the Fed has also now promised that it won't raise interest rates until 2014.

But what brought Europe back from its brink is less appreciated by U.S. investors. The European Central Bank's offer of unlimited three-year loans to banks through its Long-Term Refinancing Operation both removed the threat of systemic banking meltdown, and at the same time resuscitated moribund government and bank funding markets. The effect on European banking stocks has been spectacular. Peripheral European banks I've written about in the past, including the Bank of Ireland (IRE) and National Bank of Greece (NBG) have been on fire, up 74.2% and 85.8%, respectively, just since Jan. 1.

And yet for those of us who have been slightly underinvested since the selloff in August, it has been surprisingly difficult to make money. For anyone who looks at any of the standard technical indicators, the market has been overbought for the past three weeks. I have been waiting for a meaning full pullback to get my clients money back into the market. But like the energizer bunny, this market just keeps going and going.

For a while, I was encouraged because the recent rise has been on low volume and a lot of the smart money has stayed on the sidelines. But I'm starting to warm to the argument that since the rally has been driven purely by changed price expectations, rather than by new money coming into the markets, the rally may have a long way to. Certainly, buyers jumping in at the sign of the slightest pullback supports this thesis.

I now think it will take a Black Swan event -- some unexpectedly bad bit of bad news that will shake the market out of its complacency -- to derail it from its relentless climb.

So here is an incomplete list of three potential "Black Swans" that could derail the market in the coming weeks.

  1. Greece is still in the midst of a very complex restructuring of its debt. The latest reports are that the country has agreed to a deal in which private investors will take a 70% haircut on Greek debt. But market reaction to the latest deal in Greece is like a real world version of the "the boy who cried wolf." Investors have heard it so many times, they've stopped listening. That said, ignoring the problem does not make it go away. Meanwhile, Portugal stands ready, as the next potential domino to fall.
  2. The words Middle East and war are never good for stock market performance. Yet, the probability of Israel attacking Iran's nuclear facilities is rising by the day. Nor will Washington's accommodative policies matter much, as Israel Prime Minister Netanyahu has repeatedly compared Iran to Nazi Germany in the early 1930s. Any breakout of hostilities may cause a sharp selloff in the global financial markets.
  3. French President Nicolas Sarkozy may be quietly preparing to exit the global stage of the French Presidency -- one that has been mostly amenable to the imposition of Germanic austerity on eurozone countries. But a victory in April's French presidential elections for Fran├žois Hollande, the socialist candidate, will change the lay of the land. Hollande has promised to renegotiate the eurozone's fiscal treaty, the EU's crowning achievement of recent years. If he is successful, that could put the eurozone back into a tailspin.

Of course, the very fact that I am writing about them makes these more White Swans than genuinely unexpected Black Swans.

But the basic message remains the same: A large number of outside events could derail this market. Strong recent gains notwithstanding, this is not the time to become complacent.

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