Will China or the U.S. Kill the Rally?

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There are two looming risks that could stop the stock rally that began in March 2009 dead in its tracks. As if the world had learned nothing from the credit crisis, both of these risks are rooted in excessive debt. Which one will percolate first?

The U.S.: Public debt
Last week, rating agency Moody's (NYSE: MCO  ) warned that under current policies, the U.S.'s triple-A rating would eventually come under pressure as public debt balloons. This would likely push government bond yields up; as the risk-free rate rises, stock price multiples decline. Note that the full process doesn't need to occur immediately -- it is enough for the market to factor in an increased likelihood of this scenario to have an impact on stock prices.

China: Bank debt
Fitch, a rating agency, downgraded two mid-sized Chinese banks last week, saying it "views 'bubble risk' as greatest for Chinese banks." What is the relationship between Chinese banks and U.S. stocks, you might legitimately ask? It's partly a matter of sentiment: Investors now perceive China as a juggernaut that even a global crisis couldn't hold back, bolstering its influence on markets. In January, for example, when China announced it was tightening credit growth, world stock markets pricked up their ears.

Unfortunately, one of the ways in which China fended off a slowdown was with a flood of bank lending. Just as JPMorgan Chase (NYSE: JPM  ) , Citigroup (NYSE: WFC  ) , and Wells Fargo (NYSE: WFC  ) were shrinking their balance sheets, new bank loans in China nearly doubled year-on-year in 2009. However, the Chinese "command" approach to credit, with a system of loan quotas, is inconsistent with rational lending. Expect non-performing loans down the line -- to follow the real-estate bubbles occurring in major Chinese cities. Bubbles rarely end quietly.

Underweight the broad U.S. market
Both of these trends will probably take some time to play out. However, with U.S. stocks trading at an above-average earnings multiple, all that is required for a market correction is a change in investor sentiment on either front. The timing of such a shift is impossible to predict -- and these are just two of the risks that could precipitate one -- but I think it is fairly likely to occur this year. Now isn't the time to carry a full position in U.S. stocks through index funds such as the SPDR S&P 500 ETF (NYSE: SPY  ) .

Investors shouldn't expect any significant gains from U.S. stocks this year -- Global Gains co-advisor Tim Hanson explains why you need to own some of the top markets right now.

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You can follow Fool contributor Alex Dumortier on Twitter; he has no beneficial interest in any of the companies mentioned in this article. Moody's is an Inside Value and a Stock Advisor selection. Motley Fool Options has recommended a write puts position on Moody's. The Fool owns shares of SPDRs. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (5)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 10, 2010, at 8:17 PM, langco1 wrote:

    the rally is long over time to wake up thuis writer!

  • Report this Comment On February 10, 2010, at 9:35 PM, walt373 wrote:

    If the US loses its triple A rating, wouldn't it also lose its status as a proxy for the risk-free rate?

  • Report this Comment On February 11, 2010, at 1:45 AM, tpc616 wrote:

    The difference is, China's 3 (soon to be 5) trillion dollar reserve can back up their banking system many times over. Who's going to back up US Govt's 12 (soon to be 18) trillion public debts, if there's ever a need?

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