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How the S&P 500 Could Plummet by 40% This Year

With the Standard & Poor's 500 little changed last year, the last thing investors want to hear about is a scenario in which the index of the biggest U.S. companies plunges 40 percent.

But a market strategist at Credit Suisse says it's possible.

Global equity strategist Andrew Garthwaite, in a strategy note released Thursday, brings up so-called "tail risks," or unlikely but possible scenarios, that pose a threat to equities in 2012.

One of the biggest tail risks, Garthwaite says, is a euro zone breakup, something investors have been worrying about as the debtcrisis shows no sign of abating or being fixed quickly.

Among the potential catalysts for a euro zone breakup, Garthwaite notes the political unacceptability of the required degree of deflation, the political reaction to the loss of national sovereignty, a downgrade of Germany's credit rating, as well as the European Central Bank's unwillingness to expand its balance sheet much further unless there is a threat of deflation in Germany.

The likely result would be a drop of 40 percent on the S&P 500 to 800, Garthwaite says.

The good news, thankfully, is that he only attributes a 5 percent probability to an actual euro zone break-up.

Garthwaite is much more optimistic about the performance of the S&P 500 this year.

He reiterated his call Thursday that the S&P 500 will end 2012 at 1340, which would be 3.7 percent above the current level of 1292.

Garthwaite's year-end target is based on a weighted probability based on all scenarios.

For 2012, strategists at other investment banks like Citigroup , Deutsche Bank and Wells Fargo have an average year-end target for the S&P 500 of 1344, putting Garthwaite's prediction in the middle of the pack.

Garthwaite points out other key risks that could push equities in different directions.

They include a hard landing in China, a euro currency that goes to parity with the dollar, oil spiking to $140 per barrel due to geopolitical worries, a liquidity bubble brought on by synchronized quantitative easing measures in developed countries, U.S. Treasury yields that rise to 3 percent, and U.S. GDP growth of only 1 percent.

In his brightest, most optimistic forecast on the other end of the spectrum, Garthwaite says one surprise scenario for 2012 is that the S&P 500 rises to 1500.

That model is based on GDP growth of 3.3 percent in the U.S., which is more than a full percentage point above consensus.

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