Stock market stays resilient, but some risks are on the horizon

Los Angeles Times columnist

Crisis, what crisis?

The rebound in U.S. and foreign stock markets suggests that the storm over the subprime mortgage mess is blowing over.

But that also raises the question: What would it take to give investors a bigger jolt, and perhaps a longer-lasting one, than what they just endured?

Here are three risks that loom in the spring quarter:

-- U.S. consumer spending dives. Perhaps the surest ticket to a bear market in stocks would be for Americans to close their wallets--either because they're spent-out, or because they're nervous about their finances or their job outlook.

This is so obvious that it might well be overlooked as a risk. Investors have no recent experience with a consumer-led recession. The last one was 17 years ago, in 1990. The 2001 recession, by contrast, was led by a plunge in business outlays.

Since 2001, some analysts have repeatedly predicted an imminent pullback in consumer spending. Now the housing sector's woes unquestionably have raised the threat to Americans' shop-till-you-drop habits.

For one, the end of easy mortgage money means a large number of lower-income families now can't obtain credit. "When they can't borrow as much, they can't spend as much," said Susan Sterne, head of Economic Analysis Associates Inc. in Greenwich, Conn.

She expects real (after inflation) consumer spending to rise a modest 1.9 percent this year, down from 3.2 percent in '06 and 3.5 percent in '05.

Economic optimists say the debt problems of lower-income families won't trigger recession. The bottom 40 percent of income earners account for no more than 20 percent of U.S. spending, said Steven Wieting, economist at Citigroup Global Markets. Meanwhile, overall wages still are growing, and unemployment is relatively low.

Still, if consumer spending data disappoint in the next few months, the stock market is unlikely to just kiss it off.

-- Corporate earnings contract. Wall Street is fully expecting a slowdown in profit growth this year, with a weaker domestic economy. But an outright decline in earnings might be a shock investors couldn't handle.

The margin of safety is dwindling: Total operating earnings of the Standard & Poor's 500 companies are expected to rise a mere 4.3 percent this quarter from a year earlier. That would be the slowest growth since 2002.

If earnings were to contract, that would add to fears that an economic recession loomed.

Even a modest decline in earnings might make many investors question whether stocks are the relative bargains they're often said to be.

The price-to-earnings ratio, or multiple, of the S&P 500 index is around 17 based on 2006 earnings per share. That's modestly above the long-term average P/E. But if the "E" part starts to decline, the P/E would rise--unless share prices fell as well.

Brett Gallagher, a fund manager at Julius Baer Investment Management in New York, said he didn't believe a P/E of 17 was cheap, given the risks. "I think slower growth, lower [profit] margins and lower multiples are more likely" rather than less likely in the near term, he said.

Some have a sunnier view: Don't underestimate the boost that economic strength in China, India, Eastern Europe and other regions can provide for U.S. companies, said Jim Paulsen, investment strategist at Wells Capital Management in Minneapolis.

The global economic expansion, he said, includes "many more players, making it far stronger, more diverse and much more sustainable" than any expansion in the modern era.

-- The dollar's value tanks. The U.S. economy has been built on massive inflows of foreign money since 1980. Their saving underwrites our spending.

What would happen if foreigners lost their appetite for U.S. assets, and therefore the dollar? Granted, that question has been asked so many times that Wall Street is fairly bored with it.

Which means that a dollar crisis would be exactly the thing to catch investors by surprise.

The euro last week hit a two-year high against the dollar after Federal Reserve policymakers, who've been on hold with short-term interest rates, hinted that they're no longer leaning toward raising rates again.

This is where things get dicey. High U.S. rates, compared with the rest of the developed world, help support the dollar's value. If the U.S. economy were to weaken enough that the Fed felt the need to cut rates, the result could be a steep plunge in the dollar--which in turn could spark inflation by raising the price of imports.

If inflation rose, the Fed presumably would have to go back to tightening credit.

"The perfect storm will come when the dollar goes," said Paul Kasriel, chief economist at Northern Trust Co. in Chicago. Then again, like the Big One on the San Andreas fault, a dollar crisis might come tomorrow--or not for decades.

Tom Petruno is a columnist for the Los Angeles Times, a Tribune Co. newspaper.

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