3 Reasons Why Stocks Could Plunge

Includes: DIA, QQQ, SPY
by: Vahan Janjigian, CFA

A funny thing about the stock market is that investors seem more comfortable buying after a rally than they do after a sell-off. With stock market indices at all-time highs, perhaps investors should be exercising a little more caution at this time. Of course, there are a number of risks that investors need to worry about all the time. Some are political, some are economic, and some are company-specific. In the current environment, security selection is more important than ever. With earnings season about to kick off, here are three items that could cause a sudden plunge in the markets.

1. North Korea. North Korea explicitly threatened to deploy nuclear weapons. It is fully capable of launching a missile aimed at South Korea, Japan, and any number of U.S. allied countries in Asia. Some experts are chalking up the latest threats to nothing more than bluster and posturing from a young and inexperienced head of state who wants to cement his reputation as a strong leader at home and extract concessions from abroad at the same time. Yet, there are good reasons to take North Korea's threats seriously. The country has actually deployed missiles on its east coast and it has warned foreign embassies in its capital, Pyongyang, to consider vacating. What's worse, recent history suggests that North Korea might do something rash. While the country denies it, it was most likely responsible for the sinking of a South Korean naval ship in March 2010, which resulted in the deaths of 46 crew members. And just eight months later, North Korea attacked the South Korean island of Yeonpyeong, killing four people, injuring 19, and resulting in the evacuation of approximately 1,500. One glimmer of hope is that China, North Korea's only ally, appears to be getting fed up with the bully in the backyard.

2. Europe. First it was Greece then it was Cyprus. Portugal, Spain, and Italy are the next most likely candidates to require bailouts and bring Europe to its knees. There is something about southern Europe that seems to foster fiscal ineptitude and corruption. Cyprus was small potatoes. The country's GDP is only about $24 billion. Greece and Portugal are each about 10 times that amount. However, with economies of $1.4 trillion and $1.8 trillion, respectively, Spain and Italy are the two elephants in the room that could cause the euro to collapse. The unemployment rate in Spain is around 26%. Youth unemployment in Italy is around 37%. It's no wonder that so many young people are leaving the country. In Italy, public debt to GDP was more than 125% in 2012. There was a lot of gnashing of teeth leading up to the agreement that saved Cyprus (at least, temporarily). Imagine the turmoil Europe will face if Spain or Italy sink even further into the morass.

3. Earnings. They say earnings are the lifeblood of stock prices. If earnings rise, stock prices could continue to climb higher even if multiples contract. A good case can be made to credit earnings growth for the stock market's huge run up since March 2009. First quarter earnings season officially kicks off on Monday when Alcoa (NYSE:AA) announces its results after the closing bell. Regardless of how good or bad Alcoa's numbers are, there are already signs that this earnings season might be disappointing. Already, a number of bellwether companies, from Federal Express (NYSE:FDX) to Monsanto (NYSE:MON), have warned that earnings and/or revenues will fall short of expectations. Yet even if most companies beat reduced expectations this time, investors will pay more attention to the guidance for future quarters. Many economists are predicting strong GDP growth for the first quarter, which just closed. However, they are already reducing their forecasts for the remainder of the year.