Wealth in the balance

Last Thursday and Friday, the stock market plummeted. Is this a temporary correction before bursting through to a new high, or a sign of more pain to come?

What makes the stock market endlessly fascinating is that nobody knows the answer. But every day people make their best guess. Mine is that the potential downsides outweigh the upsides.

Downsides

• Inflation. While official government statistics suggest inflation is creeping up at a mere 3.4% a year, the actual experience of consumers suggests otherwise. The effects of nearly $3 a gallon gasoline, record costs for heating homes, rising interest rates on credit card and mortgage debt, and record health care and education costs are squeezing consumers. Since consumers account for two-thirds of GDP, there may be less money to fuel future growth. This could have a negative impact on stocks;
• Weak dollar. The dollar has lost 5% of its value so far in 2006. And it appears that the US government is pursuing a policy of weakening it further. While this weak dollar policy might help the trade deficit, it will raise the cost of imports. With the price of gold hitting a 25 year high over $7o0 per ounce, somebody out there is clearly trying to hedge against a collapse in the value of paper money. The fear underlying this appetite for gold does not bode well for most stocks -- although gold stocks are likely to benefit;
• Government and consumer debt. Consumers and the federal government are carrying record debt loads. As interest rates rise, the portion of consumer and government budgets spent on debt service is likely to rise. This crowding out effect may limit growth and could lead to higher levels of consumer bankruptcies. Such bankruptcies might also harm stocks which depend on consumer spending for growth;
• Housing. The housing market has risen substantially since 2001; however, rising interest rates have capped the rapid price increases in housing. Insofar as consumers have been using the increased equity in their homes to pay their bills, a decline in housing values could diminish the amount of money available to consumers. Moreover, housing has accounted for many jobs in the last several years and a drop in housing prices could lead to slack in this sector of the economy. Housing stocks have declined recently in response to the lower demand; and
• Political uncertainty. There are several sources of risk in the current political situation. There is concern about a possible confrontation with Iran, an increased likelihood of significant political change in Washington after the November elections, and a simmering lack of market confidence in the new Fed Chairman Ben Bernanke who has yet to establish an effective relationship with the financial markets (by contrast to Alan Greenspan). These sorts of risk make investors less willing to commit capital.

Upsides

• Corporate balance sheets. With lower tax rates, a reluctance to shoulder heavy debt, a cautious attitude towards capital investment, and the use of outsourcing to limit employee cost inflation, corporate balance sheets are strong. This positions many companies to survive an economic downturn; and
• GDP growth strong. The first quarter 2006 GDP report suggested significant economic resilience. A 20.6% increase in durable goods orders was particularly notable in light of the 16.6% decline in the previous quarter.

In my view, these risks outweigh the upside -- potentially translating into a negative stock market outlook. What's your view?