The markets are red hot this year, fueled by promising headlines about euro-zone stability and Federal Reserve interventions like Quantative Easing 3 (QE3). But is it a false sense of security? Are markets unknowingly about to be crushed by economic realities that are simply hiding in the closet? 
While a lot of attention is being given to the fiscal cliff, third quarter earnings and low volatility, there are five major economic possibilities that are not priced into this market and could catch many unsuspecting investors by surprise. Could one of these events send shock waves through your portfolio?



1. Downgrade of U.S. Credit Rating

Everyone is concerned about the expiration of Bush era tax cuts and the $600 billion-plus in required government spending cuts that will automatically take effect at the end of 2012. Everything from popular entitlement programs, such as Medicare, education and government defense spending will be impacted. And with just over a month until the presidential election, no progress on the matter is expected.

While politicians may feel they have the luxury of waiting until after the election to deal with the issue, rating agencies like Standard & Poor\'s, Moody\'s or Fitch may not be so accommodating. Each firm has warned that if a timely solution isn\'t created, it could lead to a further downgrade. As you may recall, a 2011 political fight about the U.S. debt ceiling resulted in the U.S. losing its pristine "AAA" rating from Standard & Poor\'s. On the day of the downgrade, investors had to stomach a 634 point plunge in the market (or -5.5%) -- a harsh consequence that investors may have to relive before year-end thanks to ongoing political brinkmanship.

 
2. Nuclear Tensions between Iran and Israel

Threats of violence and war are nothing new when it comes to relations between Israel and Iran. However, the intensity has been escalating as sanctions begin to take their toll on Iran and Israel threatens a pre-emptive attack to eliminate Iran\'s ability to produce nuclear weapons.

An attack on Iran would likely cause a short-term closing of the Strait of Hormuz, a vital route for transporting oil, and inevitably send the price of oil skyrocketing at a time when oil prices have already surged by double digits in recent months, thanks to the renewed tensions. According to Morgan Stanley, a $10 crude oil price increase could translate into a 45-cent rise in gas prices, and a 10-cent gas price shock would theoretically subtract 1.2% from subsequent expected S&P 500 returns.

 
3. Disputed Chinese and Japanese Territory

Recently, Japan formally purchased a set of small islands that have been a point of contention between the two Asian countries for more than 100 years. The tiff over the Senkaku islands (Japan\'s name and claim) or Diaoyu Islands (China\'s name and claim) could become a major thorn in the side of global growth at a time when we need economic stability in Asia. While it seems like a silly argument over a group of mostly uninhabitable islands, it\'s a situation that has growing economic consequences that could eventually trickle down to your portfolio.

After Japan made the announcement, it prompted violent and costly anti-Japan protests across China, forcing well-known Japanese companies, such as Panasonic, Toyota and others to suspend operations there. China has even gone so far as to curb bilateral trade and tourism with Japan. At risk here are valuable fishing lanes, along with considerable oil and mineral deposits that Japan and China want. An ongoing dispute could disrupt both economies as China relies heavily on business investments from Japan which likewise relies on China for materials for its high tech-economy. Japanese auto makers and airlines have already been hit hard as they have cut production, forecasts and flights.

 
 



4. Reserve Currency Status

For now, the dollar remains the standard for international exchange, but as the Federal Reserve plays games with the U.S. dollar and politicians struggle to get our massive debt under control, nations around the globe are evaluating whether or not they want to continue to trade in U.S. dollars. A step that some people, including billionaire investor Sam Zell, feel could lead to as much as a 25% decrease in the average American\'s standard of living.

Unfortunately, it\'s already happening. Earlier this year, China and Japan began to abandon dollar-based trade with each other... And they are not the only ones heading for the exit. China and Russia trade directly in their own currencies, as well as India and Russia. Furthermore, the main topic of a conversation between Brazil, Russia, India, China and South Africa (the BRICS nations) is also a plan to begin settling contracts in their own currencies instead of U.S. dollars: a freighting situation that could force the United States to give up its blank-check status as the world\'s reserve currency.

 
5. Hyper-Inflation Due to QE-Infinity

The concept of quantitative easing in its most basic form is an experiment that could ultimately lead to hyperinflation similar to that experienced in the late 1970s and early 1980s. Logic says that if you print money, the value of existing dollars will go down, and if more dollars are chasing fewer goods, you get inflation.

If the Federal Reserve is going to continue dumping billions of fresh dollars into the economy whenever it gets into trouble, it will inevitably lead to rampant inflation at some point. While double-digit money market and CD interest rates may sound appealing to retirees compared to today\'s rate, the fact is, dollars will be able to buy less and less. Inflation not only destroys existing wealth, but it can rob you of any sense of security as the essentials you need become more expensive. Double-digit-style hyper-inflation would essentially work like a detrimental tax that limits a person\'s ability to buy a home, educate their children and accumulate savings for retirement.

 
Action to Take --> Right now, a seemingly endless supply of money in the United States and positive news about the Euro Zone's future has provided markets with a one-way ticket straight up. However, a number of haunting economic headwinds are darkening the horizon and threatening investor profits earned. 

Whether it's credit downgrade, war in the Middle East, Asian tensions, or change in reserve currency status and hyper-inflation, investors who don't take the time to read between the lines may find themselves on the wrong side of the market's violent reaction to one or more of these issues.



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