What You Need to Know About the Market This Spring

As impressive as the stock market looked when it is was rising ever higher in 2009 and 2010, recent trading action has been even more impressive. Sure, the S&P 500 has gone nowhere for the past six weeks, but it has hung in there despite a series of shocks that would have derailed a more fragile stock market. Rising oil prices? The earthquake in Japan? Tensions in the Middle East? The seeming intractability of the European economic crisis? Nothing can dent the armor. This bull is robust.

But it’s also important not to get complacent. The market has been resilient thus far, but with the foundation taking so many hits, it may not take much more to cause the edifice to tumble. When that happens, stocks are finally likely to pull back in a meaningful fashion. Not necessarily a snarling bear market, mind you, but perhaps a 10% to 20% correction.

The good news: that could set the stage for the next bull market as the United States moves onto firmer footing. So what could finally knock the legs out from under this current bull market?

Budget wrangling gets more heated. Congress is working on continued stopgap funding bills as the two parties remain far apart on some very important issues. At some point, the appetite for more short-term funding bills may vanish and we may see another government shutdown as we had in 1995.

The market would be disrupted by such a move, as investors hate uncertainty. Yet an opposing outcome may also be true. If bipartisan legislators finally make headway and come up with a budget fix, investors will soon realize that a combination of lower spending and higher taxes is a real drag for the economy. Deficits are loathsome, but they have stimulated the economy as the government spends more than it takes in. Deficit cutting means the government is pulling money out of the economy.

Troubling inflation numbers. There’s a building debate about whether food and energy should be used to assess monthly price trends. Some consider these “non-core” items to play too important a role in consumer behavior to be ignored. And if recent agriculture and oil price trends are any indication, expect to see a spike in inflation in coming months, at least when these “non-core” items are included.

For many investors, the specter of rising prices would signal an end to the era of ultra-low interest rates. Economists predict the Federal Reserve will start raising rates next January, but if the U.S. economy looks healthier in coming reports, that start date could happen sooner. Investors look ahead and they’d prepare for the start of rate hikes before they actually happen.

The end of QE2. The Fed‘s massive $600 billion bond buyback program has been great — for investors. Some believe that was the primary catalyst for the strong stock gains posted from September 2010 through the end of January 2011, as freed-up cash went into stock purchases. That program is almost completed and now the Fed has to decide when to withdraw that $600 billion from the economy. Fed Chairman Ben Bernanke has signaled that he’s in no hurry, but many investors may not wait around, noting that all QE2-related gains have already been made anyway.

China, Japan and the Gulf. Events in any of these areas could alter the course of global trade and U.S. investors would surely be affected. China is trying to cool down a heated economy but also faces pressures that may cool the economy even faster than government planners would like. Social pressures remain just below the surface but may erupt if the Chinese economy sharply slows.

Japan’s devastating earthquake is presumed to have a minimal effect on the rest of the world, as evidenced by the fact that the S&P 500 fell just 0.6% on Monday, March 14. Yet, Japanese institutions play such a key role in global financial markets — including the United States — and if funds get withdrawn to shore up rebuilding efforts, then the liquidity impact could create a vortex for the U.S. market.

Lastly, major OPEC players are maintaining output right now, but any further political destabilization among key regional players could create even more upward pressure on oil prices. The U.S. economy may be hard-pressed to handle $120 or $130 oil.

Action to Take –>
Despite the gloomy nature of these scenarios, the U.S. economy is likely to be quite stronger than a few years ago. That’s why a market correction may not be long-lasting. But in the near-term, there are many reasons to be cautious about U.S. stocks and you may want to take profits in some of your most profitable investments.

P.S. — Few investors realize that a 20-year energy agreement between the United States and Russia is about to expire. This deal supplies 10% of America’s electricity. As broke as our government is, the situation is so serious that President Obama is asking for $36 billion to avert this crisis. And Republicans support him. Here’s what’s going on…