Saturday, January 20, 2007

Possible big issues

As a follow up to the prior post, the following is a list of a few of the big issues that could possibly do significant damage to the equity markets. Of course any point in time has its troubles ahead. We seem to have our share today. The issues here range from cyclical to structural, political, and medical. This is an incomplete list of course but there's enough here to augur against a 100% equity weighting. And the issues are:

---U.S. consumer credit---Those below the top 10% in wealth in the U.S. are awash in mortgage and credit card debt. Many adjustable rate mortages have been resetting to higher rates based on the advantaged rates offered at the outset as well as, with three year paper, the higher rates that exist today. The impact of this is only beginning to be felt. Credit card companies are now for the most part in their sweet spot(from their financial perspective) with lots of balances being carried and lots of late fees being paid. But the credit card business is a balancing act and too far in the wrong direction can bring a reversal of fortunes quickly. We have recently seen some issues in specific companies and segments of the credit card market(a few companies with higher delinquencies) and the mortgage market(some sub-prime portfolios troubled). It can be normal for companies with less technological capability or flawed underwriting standards to be the first to have issues. The question is whether issues will move into the broader market for consumer credit. With unemployment at low levels and the economy still solid most market participants are ignoring this potential issue. With wage growth low, however, and the accessing of credit ingrained in day to day life, there will likely be a day when the line will be crossed and credit, that old achilles heel of banking, will be an issue.

The new Congress question---this is a simple concern that could be important. Will a combination of conservative protectionist Republicans and labor dependent Democrats pass trade legislation that damages U.S. economic and political interests overseas and leads to inflation in the U.S. Some say that the primary focus, if legislation comes, will be China and that the wonder of globalization will quickly shift sources to other countries for many goods. That's perhaps wishful thinking and the precedent of trade barriers would be negative. Nancy Pelosi is too smart to want this but some heavyweights like Chuck Schumer(who is also smart) don't seem to care about the impact, or else see this as a bargaining chip. That could backfire.

Foreign affairs issues---Iraq, Iran, North Korea, that's the focus now, and there is plenty to worry about that could lead to some sort of shock scenario that can't be factored into valuations. But the issues with these countries are well known. Iraq's chaos is thoroughly documented, Iran is a dangerous provocateur but nothing more than that at the moment, and if North Korea does anything to mess with the Asian region prior to the 2008 Olympics, China will squash them like a bug. There are other countries, however, that should be on the radar screen and if they blow, it would exacerbate dangers in the world today. The two of most concern are Pakistan and Indonesia.

The credit derivatives market---this is the financial market that is relatively untested. It is a valuable portfolio management tool that in the long run will mitigate risk as it allows market participants to buy risk in strips and weight their portfolios with a certain degree of precision and with diversification within risk tiers. The counterparty risk, particularly as it relates to investors, has not been through a credit cycle and does have significant potential to be at least a short term disruption when it is tested, maybe worse.

Avian flu---this is perhaps an over the top concern compared to the others. It is just another distant threat in the minds of most market participants, and it may well be. It is a concern, however, among those who focus on it, much more so than is widely known. Humans have contracted it, but the good news is that it is now difficult to pass from human to human. Apparently the virus now only attaches itself to the lower parts of the lungs so that the usual means of spreading epidemics(breathing, sneezing, handshakes, kissing etc.) are not happening. If the disease adapts and begins to inhabit the upper part of the lungs, globalization would stop dead in its tracks, so to speak.

Terrorism---self explanatory threat to major countries that everyone is aware of and cannot be predicted.

There are, as stated at the outset, many more issues that one could choose as personal favorites or fears. As I reread this before posting, I'm not quite sure why I wrote it, as I've had a pretty good day and expect to sleep well tonight. I guess the point is that there are many extant issues that should temper one's enthusiasm for risk, even in an equity market as benign as the one we have had recently.


Anonymous chicken man said...

Financial firms, agricultural firms, restaurant firms, they've all spent a ton of money behind the scenes getting ready for this bird flu threat. They view it as real, and in fact have no answer if it occurs other that that they're screwed.

3:29 PM  

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