Why the Stock Market Could Crash This Year

economy and market
economy and market

Investors wondering about the U.S. stock market's future course are focusing on this question: Will the debt crisis ravaging European banks and the bursting of the Chinese housing bubble affect America's economy and corporate profits?

It's becoming increasingly difficult to claim that these global storms won't ever reach America's shores. But even more worrying -- the fundamentally unsound U.S. economy is in a poor state to withstand such shocks.

Vulnerable Corporate Profits

Many of America's premiere global companies earn most of their revenue overseas. Equipment maker Eaton, for instance, gets 55% of its sales from outside the U.S. Global companies such as Coca-Cola (KO) not only reap most of their sales overseas, they also depend on international growth to boost their profits.

So any weakening in China, the global engine for commodities and manufacturing, and Europe, the world's largest trading bloc, will have an outsized impact on U.S. corporate profits.

U.S. corporate profits will also take a substantial hit from the sudden strength of the U.S. dollar, which has risen 22% against the euro. American multinationals such as Caterpillar (CAT) have already seen their stocks pummeled as traders realize the dollar's rise will slice their profits.

Here's why. In mid-2008, when a U.S. company booked 100 euros in profit made overseas, that translated into $160 in profits when calculated in U.S. dollars. Now, that same 100 euros translates into $125, a huge reduction.

U.S. Economy's Shaky Fundamentals

But even if we set aside the European banking/sovereign debt crisis and China's increasingly shaky credit/housing bubble, there are legitimate questions about the U.S. economy's fundamental strength.

In a recent DailyFinance article on market tops, I turned to John Kenneth Galbraith's classic exploration of the 1929 crash and the resulting Great Depression, The Great Crash of 1929, for historical context.

Though the Dow Jones Industrial Average hit a new high in September, 1929, Galbraith notes that the U.S. economy in that year was fundamentally unsound. He listed five critical weaknesses:
1. Unequal distribution of income
2. Poor corporate structure
3. Poor banking structure
4. The dubious state of the foreign trade balance
5. The poor state of economic intelligence

Given the connection between these five issues and the stock market crash, we might profitably ask if any of these conditions apply in 2010. A case can be made for answering "yes" to all five.

Income inequality has risen to 1929 levels. A recent report from the Center on Budget and Policy Priorities concludes: "Taken together with prior research, the new data suggest greater income concentration at the top than at any time since 1929." I discuss income inequality further in this DailyFinance article.

The corporate structure is still filled with risk. While the most blatant misuse of pro-forma earnings has been restrained by the 2002 Sarbanes-Oxley legislation, other financial risks remain either unaddressed or only partially addressed. These include high levels of debt, over-leverage, off-balance-sheet assets, mispricing of risk and financial complexity.

Even though various financial regulations have already been tightened, the Financial Accounting Standards Board (FASB) is considering new rules to further curb off-balance-sheet abuses of the kind Lehman Brothers used to hide risk and shift assets.

Junk bonds -- risky bets on future corporate earnings -- made up the biggest share of corporate debt sales on record. That hardly suggests prudence on the part of the companies loading up on tens of billions of dollars of high-interest debt, or the investors who are betting on clear sailing ahead.

Poor banking structure: The list of ills in the U.S. banking industry is long indeed, but perhaps one fact reveals how little has changed in the past few years of turmoil: U.S. commercial banks (not investment banks) generated a record $22.6 billion in derivatives trading revenues in 2009 -- the same year that the Federal Reserve spent trillions of dollars to prop up the U.S. mortgage market and the banking sector.

While massive Federal intervention staved off systemic insolvency last year, many U.S. banks remain effectively insolvent.

The U.S. trade imbalance is growing again. Though imports fell in the recession, they rose 18% from the second quarter of 2009 to the fourth quarter. That's considerably faster growth than the entire U.S. economy, which notched a 3% gain in GDP in the first quarter of 2010.

Ultimately, the trade deficit adds to the nation's indebtedness. Though the trade deficit has dropped from the 2006 peak at $800 billion, it's still on track to reach $500 billion.

Economic intelligence is poor. Despite the daily flood of financial and economic data, pundits, government agencies and forecasters were caught off guard by the subprime mortgage crisis, the resulting banking crisis and now, once again, by the European banking storm and sovereign-debt crisis.

Many official economic-intelligence reports are of questionable forecasting value. Federal budget projections are overly rosy consistently, and the nation's GDP was "adjusted" down 37% in one fell swoop.

Earlier this year, the Labor Dept. revised the nation's employment for December, 2009, down by a staggering 1.39 million, bringing the total number of jobs lost since the start of the recession to 8.4 million. The culprit was the department's "birth-death model," which creates phantom jobs every month based on the idea that thousands of small businesses are being "born" and hiring workers, despite little to no evidence for this hiring in the real world.

With "economic intelligence" like this, no wonder 76% of Americans believe that the US economy remains in recession.

A Crash Over Several Months?

If the U.S. economy remains fundamentally unsound, as Galbraith's list suggests, then the stock market may be vulnerable to more than just a modest correction. Crashes don't always happen in a day or two -- the 1929 crash actually occurred over several months.

Risk is only readily visible in hindsight, but these five fundamental points suggest there may be a lot more risk in the U.S. economy than is widely recognized.

Originally published