Investing Knowledge

Carlsberg (Copenhagen: CARL-B.CO - news) don't make stock market rallies, but even if they did they'd struggle to brew a rush as heady as past six months.

Gaining around 60% since its 9 March low, the S&P 500 (news) rally is the US index's fastest bounce back ever, while here in the UK the FTSE 100 has added over 1,000 points in the past six weeks alone. Some specific areas such as emerging markets, commodities and individual sectors like financials and housebuilders have gone through the roof.

With events of 2008 still on everyone's mind, however, this is one of those early bullish periods where nervous investors remember that what goes up can plummet.

At times it's seemed as if the stock market advance has taken place in a different universe to the one we live in, what with the mass media's take on the economy still gloomy (even if the financial media has seen green shoots since spring) and companies still reporting plunging historical profits (albeit it anticipated by a depressed share price).

Some argue still-jittery investors are just waiting for an excuse to justify profit taking, and there is no shortage of potential bogeymen out there to inspire them.

Here are the biggest five potential scares to look out for between now and Christmas that could see buyers' take flight.

1. Banking over-regulation

Everyone wants the low-hanging fruit of bank bungling to be picked off by Governments, and we certainly need a better system of coping with the failure of large institutions.

But you can't regulate risk away entirely, and if pragmatic tweaking gives way to a vengeful clampdown, the markets would rightly fall. The finance system suffered a cardiac arrest last year, and with economies still on life support, we need capital and credit to flow freely to continue the recovery.

A dramatic regulatory experiment such as a Tobin Tax on all capital transactions, for example, would terrify investors, especially if implementation began before we're out of the emergency ward.

2. Disappointing profits

Bears argue the rally has gone too far: The FTSE is on a historical P/E of over 85!

The reason bullish investors are buying in the face of such apparent over-valuation is that just as profits were exaggerated in a boom, so earnings (the 'E' part of the P/E ratio) have been unrealistically savaged by the downturn. Last year's puny earnings figure was driven lower by extraordinary writedowns that are thought to have largely finished, as well as the 'normal' falling profits from the recession.

The expected P/E for the FTSE this year is a more reasonable 15, falling to around 12 for next year. With 2009's figures still to be reported (still to be earned!) the risks are clear -- if earnings don't soar as expected to bring the P/E ratio down, then the market is overvalued.

3. Premature withdrawal of stimulus

Gordon Brown estimated ahead of this week's G20 summit in Pittsburgh that 'only' half of the $5 trillion in stimulus measures pledged by its members had been spent, and warned it was too early to withdraw such support.

With Britain hardly the only country with stretched public finances, the temptation for any nation to quietly turn off the taps is great. But markets aren't sure the economy is robust enough yet to survive without palliative financial infusions. The choppiness in the indices this week has been put down to the Fed raising the issue of withdrawal, for instance.

4. Over-stimulation leading to inflation

Too much stimulus is better for the markets than too little, seems to be the position, but even bullish investors appreciate you can have too much of a good thing.

The worry is that if excess money is pumped into the economy then it will eventually spill over into rising asset prices and inflation. This in turn would require higher interest rates, which could eventually make holding shares less attractive in comparison to bonds and send the markets lower in the short-term (although in truly inflationary times, holding shares should prove a better bet than clinging to fixed interest).

5. The resumption of severe house price declines

The credit crisis started with loose money and lax lending, but it took US house prices declines -- unanticipated by the banks -- for the troubles to become widely apparent.

As traded securities linked to house prices started to fall, traders couldn't see the bottom, rendering the value of such assets -- and the institutions that held them -- moot. The knock on consequence was banks stopped lending to each other, fearing they might be giving money to a doomed enterprise, which effectively jammed the gears of global finance.

While it was emergency measures from Governments worldwide that halted this vicious spiral, the recovery since March has been boosted by the view that the worst may be past for writedowns of such assets, too.

While modest further property price declines have likely already been accounted for, if prices went back into freefall, bank stocks would plunge and the stock markets would turn faster than you could say "bear market rally".

Hear be monsters

You'll have heard most of these worries before, of course.

These days we all know about the rocks that holed the good ship 'No More Boom And Bust', which means everyone has an opinion on everything from the property bubble and debt to the economy and bonuses -- even if they've not lost their jobs in the subsequent crisis.

My natural inclination is to say that bodes well for further gains. If virtually everyone is aware of the risks, surely they're already in the price?

But even I acknowledge shares have moved so far, so fast that the stock market could pause for breath -- and that rather than flat-lining, shares tend to go down if they're not going up.