Markets

Everyone seems to be bullish on the stock market right now. Here's what could go wrong

Key Points
  • The stock market began 2020 at record highs, but there are a lot of things that can go wrong from here.
  • The geopolitical risks that emerged Friday with an airstrike that killed an Iranian military commander are just the beginning.
  • With stocks near record highs, companies have lofty valuations and need to show earnings growth, but so far earnings growth is looking flat.
President Donald Trump makes a statement on Iran at the Mar-a-Lago estate in Palm Beach Florida, on January 3, 2020.
Jim Watson | AFP | Getty Images

Americans awoke Friday to the prospect of war with Iran, a spike in oil prices, and a dip in the Dow Jones Industrial Average – a jarring interruption to the euphoria that had overtaken the stock market over the holidays.

"A violent escalation of hostilities between the U.S. is nearly certain in the coming days, a game changer that will obscure everything else," declared Greg Valliere, chief U.S. policy strategist at AGF Investments. "There's a reason, finally for caution in the stock market."

Geopolitical risks are always a reason for caution, but they're unpredictable and get pushed to the sidelines in a bull market. Now, they're front and center.

They have "jumped to the top of the worry list," said Alan Blinder, a former Federal Reserve vice chairman and Princeton University economics professor on CNBC's "Squawk on the Street."

Following news of the attack, strategists at UBS advised investors to stay the course.

"Individual geopolitical risks tend not to be sufficient to drive a sustained downturn in markets," they wrote, "and it is important for investors to retain a long-term focus."

Still, the escalation in Middle East tensions is a reminder that a stock market reaching for all-time highs faces risks – including high stock valuations and an aging economic expansion.

Here's what could go wrong this year for investors.

Earnings growth losing momentum

Earnings pose one of the biggest risks for stocks in 2020. Many companies have been revising their earnings forecasts lower, a trend that does not support the lofty expectations that rising stock prices have set.

Savita Subramanian, chief quant and equity strategist at Bank of America Merrill Lynch, recently put out a note saying the corporate earnings outlook is flat and that the market "feels toppy."

"Weak revisions don't bode well for early 2020," Subramanian wrote.

CNBC's Bob Pisani recently reported that analysts have cut first quarter estimates on a spate of bellwether companies. Of 15 companies with quarters that end in November, analysts cut estimates on 10, including downward revisions for Carnival, General Mills, FedEx, and Nike.

The Federal Reserve's rate cuts have allowed investors to take their eyes off earnings, said Societe Generale analyst Albert Edwards.

"One of the upsides of doing the same Global Strategy job for over 30 years is that one can more easily recognise when the equity market is a pack of cards built on shifting sand," Edwards wrote. "The US equity market has become totally detached from underlying profitability."

Many stocks may be overvalued

A trader works on the floor at the closing bell of the New York Stock Exchange, December 30, 2019.
Bryan R Smith | Reuters

At some point, companies must demonstrate earnings growth to justify their stock values.

Historically, a forward-looking price-to-earnings ratio for the S&P 500 is around 15. Today, it's about 18.

Growth stocks — particularly the technology giants Facebook, Amazon, Apple, Netflix and Google — have driven the bull market. They've also built up the highest valuations.

Frothy valuations have had many investors eyeing value stocks with lower P-E ratios since last September. Michael Wilson, chief U.S. equity strategist, believes this rotation will continue into 2020.

"We still think the greatest risk in the equity market remains in growth stocks," he wrote in December, "where expectations are too high and priced."

Companies are piling up debt

Analysts at UBS write that 2020 may bring wave of credit downgrades for U.S. stocks. If earnings are flat, economic growth is sluggish, and manufacturing stays weak, corporate debt loads could weigh on stock prices.

"It's no great secret that U.S. companies have been piling on debt in the past decade," the analysts write. "A mere ten years after the financial crisis, total non-financial corporate debt stands just shy of $10 trillion, or about 50% higher than the lows seen in 2009. Interestingly, debt is NOT a major theme in today's marketplace."

Corporate debt may become a theme, though, if companies face credit downgrades amid weakening earnings or have to refinance at higher interest rates.

The inverted yield curve could still be right

Short-term Treasurys began paying a higher yield than long-term Treasurys last summer – which is a classic recessionary signal known as an inverted yield curve.

It usually portends a downturn is on the horizon, but not right away. Lately, the curve is back to its normal upward slope on the charts and investors have forgotten all about it.

Michael Darda, chief economist and market strategist, says this is a mistake and warns investors to respect the business cycle and its indicators.

"We are somewhat baffled by the gaggle of Wall Street strategists cheerleading the soft landing based on what we believe is a faulty reading of the macro indicators," he writes. "One frequent refrain is that we now have an upward sloping yield curve and hence recession risk has evanesced. Yet, the curve is, on average, 12 months ahead of the cycle, not an instantaneous indicator of real time recession risk."

The economy may prove weaker than expected

Most economists are not forecasting a recession in 2020, but they are not forecasting gangbuster economic growth either.

"The US economic expansion is in its eleventh year," Nomura analysts recently noted. "We expect growth to continue, but at a slower pace."

The fiscal stimulus from Fed cuts and tax reform is waning, and there may not be more to come.

"Growth in U.S. trading partners has slowed," the Nomura analysts wrote. "Uncertainty surrounding economic policy and the business environment generally has increased and is depressing investment. Activity in the industrial side of the economy remains particularly weak."

A sharp and sustained rise in energy prices, due perhaps to Middle East tensions, could also tip the economy and the stock market.

"One of the things that can derail a bull market is a spike in oil prices that can cause a recession," said Paul Hickey, co-founder of Bespoke Investment Group. "When you have higher oil prices, that's going to impact a key cost for a lot of different businesses."

Stock meltdowns do not require recessions

Crowds gathering in front of a monitor in the window of Dean Witter Reynolds, October 20, 1987, checking on the course of the stock market the day after Black Monday.
Marty Katz | The LIFE Image Collection | Getty Images

Recall that stocks came close to a bear market in December 2018 with no recession in sight.

"You don't have to be in a recession to get an extremely negative return," write Bernstein analysts Philipp Carlsson-Szlezak and Paul Swartz.

There was no recession on Black Monday of 1987, or during the bear markets of 1966 and 1962, the analysts noted.

We could see a spike in inflation

Commodity prices are on the rise. Oil, in particular, could be higher throughout 2020 amid events in the Middle East. Additionally, unemployment is at 3.5% and wages are on the rise, which may force businesses to raise prices,

"There's going to be an inflation scare," predicts Marc Chandler, chief market strategist at Bannockburn Global Forex. "Headline inflation is going to move up."

Chandler said it could be enough to spook markets, but not enough to move the Fed.

The Fed may not be able to sit pat

Federal Reserve Board Chairman Jerome Powell testifies during a full committee hearing on "Monetary Policy and the State of the Economy" on July 10, 2019 in Washington,DC.
Brendan Smialowski | AFP | Getty Images

Fed Chairman Jerome Powell has signaled that the Fed does not anticipate making any changes to its key interest rate for the foreseeable future.

A sharp increase in inflation, however, could force the Fed to raise rates, which could topple a market accustomed to ultra-low rates. It would also pressure companies with large debt loads.

Conversely, there's always the risk of an economic downturn that pushes the Fed to lower rates. There's also President Trump who has a tendency to criticize the Fed for not lowering rates to zero. But if the Fed were to change its stance and lower rates, it could send a mixed signal to markets.

Lower interest rates typically boost stock prices, but if Fed cuts are viewed as emergency measures, investors could lose confidence in the economy, sending stocks lower.

It's going to be a divisive election year

House Speaker Nancy Pelosi (D-CA) speaks next to House Judiciary Chairman Jerry Nadler(L), Democrat of New York, House Permanent Select Committee on Intelligence House Committee on Oversight, and Reform Chairwoman Carolyn Maloney(R), Democrat of New York to announce articles of impeachment for US President Donald Trump during a press conference at the US Capitol in Washington, DC, December 10, 2019.
Saul Loeb | AFP | Getty Images

America will be even more divided with an impeachment trial looming and House Speaker Nancy Pelosi now challenging President Donald Trump's decision to launch the airstrike that killed Iran's top commander, Gen. Qasem Soleimani, in Baghdad.

Growing contentiousness could take a toll on consumer confidence and slow consumer spending, which has kept the economy humming though 2019.

"We expect this year's presidential election to be even more contentious than it was in 2016 — which will likely place a damper on retail sales," wrote analysts at Loop Capital Markets.

The trade war isn't over

Chinese President Xi Jinping (R) waves to the press as he walks with US President Donald Trump at the Mar-a-Lago estate in West Palm Beach, Florida, April 7, 2017.
Jim Watson | AFP | Getty Images

Trade tensions have eased with President Donald Trump's promise to sign a phase one trade deal with China on Jan. 15. Additionally, the market is expecting tensions to remain subdued in an election year.

Still, it's not fully clear what the phase one deal contains, and the biggest differences between the two nations have yet to be resolved

Additionally, trade war optimism from President Trump, which frequently swung markets higher in 2019, may not work anymore, says former J.P. Morgan Chase executive Adam Crisafulli, now founder of Vital Knowledge Media.

We "won't have the vapid 'We're close to a Big Deal!' tweets any longer to count on for cheap rallies," he writes. "It will now need to see genuine growth/earnings improvement to justify further gains."