The Biggest Market Risk For The Rest Of 2016

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The U.S. stock market continues to muddle along and is set up reasonably well for a year end rally.

But the headline S&P 500 Index is not without its risks as it drifts toward the end of the year.

One risk in particular looms large before the year draws to a close not only for U.S. stocks but capital markets in general.

Although the U.S. stock market is barely higher than it was nearly two years ago when the Fed's QE3 mega stimulus program came to an end, it did recently touch new all-time highs as recently as August. It did also bounce back impressively from its tough start to the year and has shown much more verve than its developed market counterparts across the rest of the globe in regaining its footing. Moreover, it appears to be increasingly setting up for a solid year end rally post election during the historically supportive months of November and December.

So Many Risks To Consider

The resilience of the S&P 500 Index (NYSEARCA:SPY) during the post crisis period has been remarkably impressive. No matter what has been thrown at the large cap U.S. stock market over the past seven years, it has shaken it off and continued to ride on. Of course, the last two years have given the buy-and-hold crowd little to get excited about and much more to lose sleep over along the way. But the fact that the S&P 500 Index is still holding its ground despite all of the challenges it has faced since late 2014 is an accomplishment in its own right. After all, its developed market counterparts (NYSEARCA:EFA) across the rest of the world have not held up nearly as well.

But despite its seemingly unbreakable run, the S&P 500 Index faces a litany of obstacles in trying to maintain its footing much longer. These include but are not at all limited to the following:

The S&P 500 Index is now trading at more than 26.2 times trailing as reporting earnings. This is a valuation that is venturing well into tech bubble territory at this point and comes at a time when corporate profit margins are in decline. And while extreme valuations during the tech bubble were heavy concentrated in selected sectors such as technology (NYSEARCA:XLK), media and telecom (BATS:IYZ), today's frothy valuations are more evenly spread across the entire sector spectrum. Put more simply, unlike the tech bubble, no stock investors should consider themselves safe from the effects of the next bear market once it finally arrives.

Beyond fundamentals, the U.S. Presidential election looms as a short-term downside risk in the coming weeks and potentially beyond depending on the outcome. Markets will likely feel reassured that an uncertainty has been removed come November 8 regardless of the outcome. But selected scenarios such as a Trump victory or a Democratic sweep that includes a takeover of both the Senate and House of Representatives might give the market pause in the election's immediate aftermath given some of the greater uncertainties (Trump being a more unknown quantity when it comes to policy, greater likelihood of changes to the status quo if Democrats fully control both the executive and legislative branches).

Other notable risks include the ongoing depreciation of the Chinese yuan currency (NYSEARCA:CYB), the ongoing instability in the European banking system (NASDAQ:EUFN), and the increasing realization that risks associated with 'Brexit' did not end but only just started with the conclusion of the vote back in late June.

One other persistent risk is the ever present potential policy mistake or unexpected shift. This would include most notably a major global central bank suddenly shifting toward a more tightening policy stance. This risk is most pronounced out of China (NYSEARCA:FXI), which has recently been draining liquidity out of its financial system. While everyone refers to the so called 'taper tantrum' of May-June 2013 as being the reason for the sudden and sharp stock and bond market sell off at the time, the far greater reason was the fact that the Chinese (NYSEARCA:GXC) interbank lending market had effectively seized up at the exact same time.

The Greatest Risk For The Rest Of 2016

But the greatest risk for the rest of 2016 is the following. It is the constitutional referendum vote in Italy (NYSEARCA:EWI) set for Sunday, December 4.

Why exactly would global investors care about the outcome of a constitutional referendum in Italy in the coming weeks? Because the outcome has the very real potential to turn what was an isolated incident in the United Kingdom (NYSEARCA:EWU) leaving the European Union (BATS:EZU) suddenly into a trend.

How can this possibly be the case? Current Prime Minister Matteo Renzi of the mainstream center-left Democratic Party took power in 2014 with the mandate to enact reforms that included changing the constitution to allow for the formation of a stronger controlling government to carry out fiscal policy more effectively in support of the Italian economy. The bill for the referendum was first introduced in mid 2014 and was originally seen as receiving strong and widespread support from the voting public.

As we have progressed through 2016, the outcome of the vote has become far more uncertain. What had once been a 60% to 20% margin in favor of 'yes' has become in recent months a narrow margin in favor of 'no'. For example, of the last sixteen polls conducted on the referendum since late September, fourteen of these polls have shown 'no' in the lead both among 'decided' and 'considering' voters by an average margin of 3.4%. Given that Mr. Renzi has staked his political future as Prime Minister on a 'yes' outcome on December 4, the stakes are becoming increasingly high not only for Italy but also the European Union, the entire world and its financial markets.

But so what if a 'no' vote pushes Mr. Renzi out of power? The issues here are several.

First, Italy is currently trying to deal with a banking system that is currently in tatters and on the verge of full blown insolvency (a number of banks are already insolvent, but the market is not fully reflecting it as of yet). As a result, the departure of Mr. Renzi would inject added uncertainty to an already fragile situation. And as we learned all too well during the financial crisis, a banking problem in one part of the world can quickly spread to become a banking problem throughout the world. And with recently challenged banks such as Deutsche Bank (NYSE:DB) and Credit Suisse (NYSE:CS) living close by in Germany (NYSEARCA:EWG) and Switzerland (NYSEARCA:EWL), the spillover risks of a messy resolution to Italy's banking woes should not be overlooked.

Also, the departure of Mr. Renzi from his role as Prime Minister would leave a void to be filled. And this would leave the door wide open for the upstart and far left Five Star Movement (M5S) behind its founder and comedian/actor Beppe Grillo to assume power. The party, which was first formed in 2009 and most recently grabbed headlines for Virginia Raggi's victory in Rome's mayoral election with mixed results since, was founded on a populist, anti-establishment, and Eurosceptic platform. Put simply, it is a party whose foundation is formed on being against the European Union and its euro currency. As a result, the ascent of Mr. Grillo into the leadership role could bring with it the uncertainties as to how much Italy may be willing to comply with the demand of the European Union in a relationship that is already strained under Mr. Renzi.

It is also worth noting that the leadership of the Five Star Movement continues to endure growing pains of its own despite its sharp rise in popularity. For example, Mr. Grillo just this month dissolved the five member leadership Directorate of the party and declared himself the political head of the movement. As a result, if the M5S were to assume control of Italy, the structure of decision making authority within the party would also remain a question.

But so what if Italy moves under control of a more unknown style of leadership and starts to push back on the European Union? We saw the same thing with Greece (NYSEARCA:GREK), after all, and didn't this just end up fading away from the headlines? Before going any further, it should be noted that Greece is not a situation that is gone from the headlines, as the previous "solution" from last summer has only postponed the next round in the ongoing saga with the European Union to a later date. But unlike Greece that is a relatively small economy in the EU, Italy is the eighth largest economy in the world, the fourth largest economy in the European Union and the third largest economy using the euro currency (NYSEARCA:FXE). In short, it is a big dog. Moreover, while it is the eighth largest economy, it is the third largest debt market in the world. In other words, Italy has borrowed a lot of money along the way that will eventually need to be either rolled over or paid back.

The Potential For Added Strains On The European Union Experiment

Putting this all together, a 'no' vote on the Italian constitutional referendum in the upcoming weeks on December 4 has the potential to start a chain reaction that could result in the far left M5S under Beppe Grillo seizing power and Italy potentially looking to follow in the footsteps of the United Kingdom in working their way out of the European Union. Even if such a chain reaction is not ignited given a 'no' outcome, the associated uncertainty may simply be enough to rattle the cage of a U.S. stock market that continues to drift along on a lofty perch.

What categories would be the likely winners from a 'no' vote out of Italy on December 4? Leading among these would be U.S. Treasuries (NYSEARCA:TLT), as a 'no' vote would not only likely send the skittish Federal Reserve to the sidelines from raising interest rates at its next 'live' policy meeting on December 14, but it would also stoke safe haven demand along with deflationary pressures that are both bullish for U.S. Treasuries. Consumer staples (NYSEARCA:XLP) and utilities (NYSEARCA:XLU) stocks would also likely receive a boost, as both defensive sectors have been highly correlated with the U.S. Treasury market over the past few years. Another category that would also likely benefit, perhaps not immediately but eventually, is gold (NYSEARCA:GLD). For not only would the yellow metal get a boost from the Fed getting sent to the sidelines, but it also stands to benefit as an alternative global reserve currency from the increasing notion that structural underpinnings beneath the euro currency may actually be at risk.

Bottom Line

The S&P 500 Index continues to muddle along. And while the U.S. stock market may be setting up for a solid year-end rally during the seasonally favorable months of November and December despite the various challenges it continues to face, one risk in particular in the Italian constitutional referendum on December 4 looms large in its path between now and the end of the year. Investors will be well served to monitor events closely as they unfold and adjust accordingly depending on how events appear set to play out.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I am/we are long TLT, PHYS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long selected individual stocks in the consumer staples and utilities sectors. I also hold a meaningful allocation to cash at the present time.