I don't think I really need to talk too much about the possibility of the US Fed increasing interest rates earlier than everyone thinks. I've stipulated many, many times the end of near-zero interest rates and QE3 will cause some serious disruptions. Especially since the world has been so used to it for the last 5 years and so many little bubbles have been popping up all over (e.g., bitcoin, Asian housing prices, social media).
What I want to talk about today is 'credit' - a relatively simple and boring concept that will be the key driver to understanding this year's stock market. A smooth credit system is what allows individuals and institutions to live and prosper above their means. It allows economies to prosper, and equally to wither when it is disrupted.
The current market is in an interesting flux with credit as a vague idea being withdrawn from the market, ie. the withdrawal of QE3 which isn't directly a hike in interest rates or precise withdrawal of credit/lending. The US economy continues to grow steadily despite weather disruptions (see the Feb jobs number) and QE3 tapering continues. While this isn't exactly credit tightening, the withdrawal of money from the market will have intriguing consequences. For the forward-looking stock markets, even the expectation of withdrawal of money will be influential.
We've already seen early signs of this distress and disruption from more heavily debtor/deficit nations like India, Indonesia, Kazakhstan, Ukraine, Argentina, South Africa, being forced to hike their own interest rates to try to stem too much capital flows from leaving their countries. On the other hand, New Zealand became the first developed market to hike their interest rates by 25 basis points for completely different reasons (because they are doing well, too well for their central banker). All in all, credit is leaving this world and flying back into the world central banks.
In fact, the largest risk to the US stock market is an improving economy, in an indirect way. This is counter-intuitive logic. To the normal layman, a stronger US economy economy should result in stronger orders/demand for products/services for the rest of the world, pulling global growth upwards. But what will more likely happen as a twist will come back to the concept of 'credit'. As the US economy grows, QE3 continues to be pulled away, interest rate hikes start coming, and bonds/treasuries start selling off in expectation of higher inflation, the borrowing cost for the rest of the world will increase. Credit starts to get withdrawn from countries/institutions that shouldn't have received so much of it previously. Analogous to the sub-prime crisis in 2008, you can think of countries like Argentina, South Africa, Indonesia as being 'sub-prime' (the culprit, rather than the fall of housing prices, will be the fall of commodity prices). And when one or a chain of these sub-prime countries start running into problem, you can be sure it will affect the US stock market which doesn't trade particularly cheaply after being in a bull market for the last 5 years.
At the beginning of the year, many pundits claimed that a rising US economy would bring up the rest of the global economy. The opposite may just happen as credit tightens around the world. Instead of the US bringing up the rest of the world, the rest of the world has the potential to bring down the US stock markets.
What to do today then? You can play a trader and go long US equities until bond yields start spiking, and then start reversing your trade. Or you could hop on the emerging market bear train - being naturally contrarian, I sure hate going with the bearish-on-emerging markets crowd, but it looks like they may just win it out this year. Pick and choose your strategy wisely and don't forget to keep some cash, a great multi-year long/buying investment opportunity is coming full steam ahead!
