The two main threats to markets today – and how to avoid them

Optimism is creeping back into markets.

In the US, earnings season hasn't been spectacular so far, but it hasn't been awful either. The housing market is improving too.

In Europe, the European Central Bank stands ready to act, as soon as Spain asks it for help. The International Monetary Fund is now telling everyone to abandon austerity in favour of more spending.

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So it's perhaps little wonder that analysts are getting more excited. As the FT notes, some are now calling for the S&P 500 to hit an all-time peak before the end of this year.

After all, with the Federal Reserve promising to print as much money as it needs to, and other global central banks following suit, what can go wrong?

Well, I can think of at least two things

Europe's leaders are getting complacent - again

There are at least two major threats that could derail the market's current upbeat mood.

Earlier this year the world was going to end (again) as some of Europe's biggest economies threatened to run out of cash. Borrowing costs for Spain and Italy spiked, while Greece looked increasingly at risk of toppling out of the eurozone.

Today, nothing very substantial in real terms has changed on that front. Spain is still in a lot of trouble. Bad debts continue to pile up at its banks and the situation could get a lot worse before it gets better.

But the promise of money-printing from the European Central Bank (ECB) has persuade investors that everything will be OK in the end. As a result, Spain's bond yields have slid, along with Italy's, while stocks have bounced sharply.

Now, I happen to think that investors are right to have bought stocks in these markets indeed, we tipped them back at the height of the panic. And I can see them enjoying further significant gains over the next few years.

However, there's every chance there could be another panic between now and actual money-printing starting. In fact, it's a near-certainty - this is how it always works in the eurozone.

The market drives a country to the point of bankruptcy by pushing its bond yields to panic levels. European leaders have a crisis summit. They come out with some grand plan that takes the eurozone just a little bit closer to full-blown money-printing. The market rejoices, and bond yields fall.

Then we wait. And wait. And nothing happens. Because bond yields have fallen, the politicians lose their sense of urgency. No one wants to beg for a bail-out. It's not the sort of thing that goes down well with the voters. So they'll only do it if they're forced.

It's already happening. Aid for Spain is not officially on the agenda of the EU summit this week. It might take a while to dawn on investors, but it's likely to take another surge in bond yields to force matters.

I'd still be happy to hold on to European stocks. They're cheap enough to be a decent long-term investment. But having bounced so strongly since the summer, don't be surprised if there's a bit more turbulence in the months to come.

Will the US fall off the fiscal cliff?

Another big threat is the fiscal cliff' in the US. It looks like Barack Obama will win the US election in November, but regardless of what happens, America's politicians will have to come together to work out how to tackle the country's deficit. If they can't agree a deal, then between higher taxes and spending cuts, a big chunk of the country's GDP could be lopped off next year.

Investors are currently in a good mood. So they're looking on the bright side. They think that whatever happens, the politicians will pull some sort of deal out of their hats before the deadline.

But that's a very optimistic viewpoint. Remember last summer's big fight over the US debt ceiling? Nobody believed that US politicians would go to the wire on that one but they did. It directly led to S&P downgrading America's credit rating. That downgrade had no practical impact, but the point is, betting on co-operation between US politicians is by no means a sure thing.

We've already mentioned a few times that US stocks look expensive as judged by a long-term valuation measure like the cyclically-adjusted p/e ratio. And you only need to look at Google's nasty fall yesterday to see what happens in an expensive market when disappointments happen. So in general, we're not keen on US stocks just now.

What else can you buy?

So what else can you invest in?

One thing I wouldn't touch is bonds. I read an interesting piece on the Timely Portfolio blog this morning. It calculated that even if the US 10-year Treasury bond yield was to fall to 0%, the price of the bond would only rise by 17%. That's not much upside for a bet on a very extreme, "end of the world", scenario.

And in general, there's too much interest in bond markets for my liking. Every other week some company or other raises a load of new debt at knock-down prices. When companies are rushing to borrow money, who's really getting the best deal the lender or the borrower? I'm going to bet the borrower.

One other market that does look interesting though is Japan. As we've noted before, Japan's currency is one of the main things holding its stock market back. The yen is a bit of a safe haven' currency - it strengthens when investors get worried. And there's been a lot of that about.

But at the same time, the Japanese market is so bombed out that it's hard to see a lot of downside from where it is now. If markets do go into full-blown risk-on' mode, the yen is likely to weaken, which could be a great boost for Japanese stocks.

None of us can predict the future but in terms of risk versus reward, I'd say Japan looks a better bet than the US today.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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