The great bull market has sent major market indexes around the globe vaulting from record to record in 2017, making many investors euphoric. The latest upward spark is tax reform legislation that's likely to be approved by the U.S. Congress. From a great height comes a potentially great fall, however, and a wide-ranging cover story in Bloomberg Markets takes a look at what could send the markets over the edge. Bloomberg interviewed a number of investment professionals, who gave 12 reasons for investors to be concerned.
1. Vicious Feedback Loops
Computerized quant funds created a panic in 2007, when funds pursuing similar strategies sold heavily, sending prices spiraling swiftly downward, and prompting yet more waves of selling in a vicious feedback loop. Accelerated by high-frequency trading (HFT), these deadly downdrafts can crush the markets in minutes. (For more, see also: Could Algo Trading Cause a Bigger Crash Than 1987?)
2. Cyber Insecurity
As the financial markets are increasingly computerized and exposed to the internet, the odds of a catastrophic event stemming from hackers or systemic failures multiply. The parade of data breaches at major corporations and governments are evidence of the growing dangers. (For more, see also: Cyber Wars: How The U.S. Stock Market Could Get Hacked.)
3. Bubbles in China
Chinese banks may be sitting on a mountain of bad loans, perhaps 20% of their total portfolios. Debt has ballooned to about 215% of GDP, the real estate market shows signs of speculative excess, and an increasing number of zombie companies are being kept afloat. When these bubbles burst, the impact will be felt worldwide.
4. Stock Exchange Crunch Time
U.S. stocks have 12 official public trading venues, which provide backup for each other. However, during the final 15 minutes of the day stocks trade only on their home-listing exchanges. Here closing prices are determined, vital for valuing a host of positions, accounts and portfolios. Current backup procedures in case of technical failure or cyberattack may not be robust enough, especially if order flow is particularly heavy.
5. Crowded Indexes
The rush to invest in index funds and ETFs have created a very crowded set of investments, with valuations of their components being pumped up ahead of fundamentals. When investors sell en masse during a market decline, a crash of epic proportions may ensue.
6. Crypto Crash
Cryptocurrencies such as bitcoin have a relatively small combined value right now, and their pricing on unregulated exchanges limits their appeal to cautious mainstream investors. However, they are likely to enter the mainstream if derivative products based on them are approved, such as options, futures and ETFs. This would magnify the dangers of a crash in their already volatile values. If digital currencies ever get accepted as loan collateral, a replay of the subprime meltdown may be on the horizon. (For more, see also: Nasdaq Will Add Bitcoin Futures in 2018.)
7. Overdue Recession
The current economic cycle inevitably will turn from expansion to recession. The only question is when. Meanwhile, quantitative easing by central banks has sent investors headlong into riskier assets in desperate search for ever-diminishing yields. When the recession finally comes, perhaps the result of excessive tightening by the Federal Reserve, a bear market should follow, and these risky investments will be hit especially hard. (For more, see also: Get Ready For The Coming Bear Market and Recession.)
8. Financial Domino Effects
The financial crisis of 2008 was a lesson in how a supposedly limited problem, such as mortgage defaults in the U.S., could trigger a worldwide financial and economic near-collapse. Lehman Brothers offered a corollary lesson about the domino effect from counterparty risk. The next eurozone debt crisis may be a catalyst for a global crisis, sped along by the post-Brexit cracks in EU solidarity.
9. Japanese Debt Bomb
Japan leads all industrialized nations with debt at 240% of GDP. The aging population will send medical and nursing costs up rapidly, increasing the debt load, eventually sparking inflation, and thus likely to send Japan into financial crisis.
10. New Oil Glut
If an oil glut sends prices below $30 per barrel, oil consumers would cheer. However, marginal U.S. producers with low credit ratings would be unable to pay their bills, perhaps setting off a wider crisis.
11. Repo Choke Point
By mid-2018, only Bank of New York Mellon Corp. (BK) will provide clearing and settlement services for the $2 trillion U.S. market for repurchase agreements (repos). JPMorgan Chase & Co. (JPM), the only other player, is exiting due to regulatory capital requirements that it finds too onerous. A breakdown at BNY Mellon could cripple the $14.3 trillion market for U.S. Treasury securities, and reduce liquidity for traders in stocks, corporate bonds, and currencies.
12. Crisis of Confidence
Once a crisis of investor confidence sets in, frothy asset prices will plummet, and leveraged trades will unwind rapidly. Such a crisis can be sparked by political, as well as economic, events. In the bear market of 1973 – 74, the S&P 500 dropped 45%, exacerbated, if not caused, by a perfect storm of events, as noted by longtime Wall Street Journal columnist Jason Zweig: war in the Middle East, a quadrupling of oil prices engineered by OPEC, the Watergate scandal that led to the resignation of President Nixon, and a spike in inflation, itself partly due to OPEC.