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3 risks that could crash the market

Data points suggest market participants use caution.

  • By Jeff Reeves,
  • MarketWatch
  • – 01/21/2014
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After a roaring run for stocks in 2013, there are some signs of trouble on the horizon.

December's job report was ugly. Earnings warnings have picked up. And, of course, there's that pesky problem with the Federal Reserve starting to ease off the gas.

Investors certainly shouldn't panic. And for the record, I remain a long-term bull on the stock market and the American economy in general.

However, it's normal to start wondering if we're poised for a pullback in the next few months.

After all, 2013 was almost nowhere but up. The biggest "correction" for the S&P 500 (.SPX) was a roughly 6% slide from May to June ... and you had to time the volatility perfectly (horribly?) to feel that loss and not get the snapback that followed.

I'm certainly not wishing for a pullback, and I'd love to see stocks power higher in a straight line. Still, I'm keeping an eye on three major areas of concern right now to gauge the state of things.

Here they are, and here's what you should look for as signs of a breakdown:

Jobs news

December's report was freakish, with a mere 74,000 jobs added, for the slowest pace of job creation in three years.

This, despite expectations of 196,000 jobs. Equally odd, a separate ADP report coming in at 238,000 jobs to top forecasts and mark the strongest pace in 13 months.

So, one of two things are true. The first scenario is that December's report was an outlier, and we will see a robust January report and big revisions for December.

This is a real possibility, given the "polar vortex" disrupting a lot of jobs and the inherently volatile nature of these labor statistics, particularly amid seasonal hiring around the holidays. Consider that the latest report added 38,000 more jobs to November's numbers, an almost 19% bump. It's not uncommon for tens of thousands of jobs to be added in the following months as data is refined.

Of course, the second option is that December's jobs numbers weren't a fluke.

It's crucial for the January jobs numbers to improve markedly on December's to maintain the narrative of recovery. But considering Macy's (M) just announced 2,500 layoffs and Dell just divulged it's cruising toward massive cuts that may total 30% of its workforce ... well, color me skeptical.

Mark your calendar for Friday, Feb. 7. It's going to be a big day for the markets when January jobs data hits.

Ugly earnings

On jobs: Remember, corporate profits aren't up because of hiring and expansion. They're up because of cost cutting and stock buybacks.

And in 2014, the analyst community seems to think the earnings lift will continue.

The consensus estimate is for double-digit profit growth this year leading to a record earnings per share of $120 for the S&P 500. Some folks are even predicting this is the year revenue trends turn around.

But here's the thing: Wall Street analysts are often wrong, and even more frequently err on the side of optimism. And in the cold light of day, they end up eating crow.

Consider that the number of negative pre-announcements from S&P 500 stocks has hit a record, with almost 20% of the components (94 as of this week, according to FactSet) saying as much.

Now consider the big moves from highfliers that have failed to deliver on profits. Lululemon (LULU) imploded after warning its fourth-quarter earnings will be bad. The story is the same for stocks like SodaStream (SODA) and Gamestop (GME) and Best Buy (BBY) that posted disappointing outlooks.

The bar is clearly moving down, not up.

Now, a handful of stocks are bad every quarter, and downward revisions are part of the game. The market has managed to hang tough and post a few more record closes in January, despite these earnings concerns.

Heck, the market ran up for all of 2013 amid the same chatter. Profit margins have been at record highs for a while and haven't cracked, so why would they this earnings season? Or the next?

That's the million-dollar question, and a huge risk to watch. If corporate profits remain strong in the face of revenue challenges, or if we see signs of long-awaited revenue growth, then the music keeps playing, and we march ever higher.

But any signs of a breakdown will certainly spark a run for the exits.

Lending drought

Parsing bank earnings specifically from last week, lending rates are a particular area of concern.

Wells Fargo (WFC) managed to post an 11% jump in profits on cost cutting, but mortgage lending was at the slowest pace in five years. A gut-wrenching 60% drop year-over-year for the nation's largest mortgage lender is worth noting.

Another disappointing data point: Consumer credit in November grew by the smallest amount in seven months, with credit-card use in particular slowing sharply.

I'd prefer not to get lost in a philosophical argument about whether debt is "good" or not. But hopefully we can all agree that increased lending is frequently is a sign of economic growth and increased risk appetite. On the other hand, a contraction in lending is a sign of risk aversion and decreased liquidity as banks and debtors alike hunker down.

These are oversimplifications, yes. But broadly, which of those two phases would you like to be in — credit contraction or credit expansion?

Interest rates are still relatively low, and it's not like we are in a credit freeze. But one of the narratives we were fed last year is that consumers are spending more on cars and houses, fueling economic expansion.

A slowdown in credit would mean the opposite.

It's not just U.S. lending, either, that's worth watching. Consider that despite a number of improvements in Europe across 2013, credit growth remains miserable, or more accurately, it means credit contraction. The finance blog Sober Look has a host of great charts that illustrate this, with loans for both consumers and business at rates not seen since 2009. Are we really to believe Europe is on the rebound when the region is lending and borrowing less then even before the euro debt crisis?

Credit is crucial to so many parts of this recovery, for stocks and the economy.

If reports continue to show slowing lending in the U.S. and around the world, it could get painful for investors.

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