Are Stocks Cheap Part V {Market Risk in 2011}

This week we are going to conclude our series on whether stocks are cheap. In our last installment we discussed the impact of volatility on markets. Today we are going to discuss what are the things that could possibly impact stocks to the negative and the probability that they could do so.

First we should mention that the investment community is much more uniformly bullish than they were a year ago at this time. Most are doing some of the same basic math as us me and so you see most brokerage price targets in the 1,350-1,40 range on the S&P 500. That by itself is cause for concern in some quarters as many view the herd mentality of the investment business often as a contrary indicator.

The most important thing that could go wrong with stocks would be an economy that begins to falter. The first warning sign of this will be when we see four quarter forward looking earnings estimates begin to flatten out or decline. This was one reason for the market's decline last spring. The European debt crisis seemed to come forward out of nowhere to most investors. Economists slashed their forecasts on world growth and stock analysts cut their earnings estimates. Fears of a double dip in the economy rushed to the forefront which weakened investor sentiment. Investors pulled money off the table and stocks declined till their reached a level of fair value. Markets picked up as those fears versus economic growth proved unfounded and earnings estimates began to increase.

So far there is no indication the process of declining earnings revisions is occurring. In fact the opposite has been happening as evidence of a world-wide pick up in growth continues to come in. It is not that investors have no worries. For example there is concern that China may overshoot in trying to curb its economic growth, concern over the US housing market, the slow pace of our job improvement and the European debt crisis continues to fester. But it strikes me that these issues {as well as a few others which space prevents me from discussing} are currently discounted by stocks. Stocks are currently trading at about a 13.5 PE to their forward looking averages. This is historically cheap in a low interest rate environment and likely reflects most of these ongoing concerns. Unless earnings begin to decline again, that sort of PE should also put a floor under most declines.

What would likely knock the market off its axis is a major event coming over the transom that is unforseeable and considered a lasting event with a large economic impact. I will list what some of these are that I can see with a brief comment where necessary. If such an event should occur though it will likely be one that I haven't thought of here.

1. Default of one of our states or a major municipality. This recession has hit governments hard at all levels. Analyst Meredith Whitney-She's the one who accurately predicted the 2008 financial crisis- went on the television show 60 Minutes last year and brought this issue to the forefront. While I won't dismiss this as a possibility, I think it is a much lower risk event at least for this year than perhaps she believes. Nobody wants to be shut out of the bond markets and such an event would all but slam that door closed for a long period of time. Look for some smaller cities to maybe file for bankruptcy. It has happened before the most notable being Orange County back in the 1990's, but I think a spillover event is unlikely. Most states will do what Illinois just did, raise taxes.

2. Terrorist event. It would have to be as big as 9/11 or have a much broader economic impact. So far nobody has demonstrated the ability to do that anywhere in the world. Events like the Tuscon massacre last week didn't move the needle a dime in the markets. In any event one cannot manage money anticipating this sort of thing. It could happen tomorrow or it could happen never. Better to have a plan for how to react in the event this occurs instead.

3. Natural disaster. This is the thing I worry about the most. The United States is a country covering a broad landmass with different geographic features. A massive natural disaster; major hurricane hitting in New England {we covered this years ago here } or an earthquake in LA or along the New Madrid fault could be such a profound economic shock that it could send the market into a tailspin. Again you can't manage money for such an event. But it is the one I think with the highest probability that could occur.

4. Major war. The only real place this could happen is in Korea and that looks contained for now. The other place is between Israel and Hezbollah and that kind of event probably won't move the needle.

Finally while some of these events may be unknowable. Part of the playbook is to have a game plan in place for what we would do for clients in the event something along these lines would occur. In our next post we'll use charts to discuss a likely glide path for this year. We'll end this series with a discussion on what the playbook says we ought to do.

*Long ETFs related to the S&P 500 in client accounts.