Which Is A Bigger Threat To U.S. Stock Market - Declining Earnings or a Shock From Europe or Iran?

Now that the Santa Claus rally has failed to materialize, what's next for the U.S. stock market?. The latest reports on retail sales, the housing market, and auto sales all provide support for the widely espoused predictions that the gradually improving economy will lead to an upbeat year for stocks. However, the following factors all suggest that it may be tough sledding for the stock market over the next few months:

1. Earnings contraction due to pressure on profit margins and slowing sales to Europe. Nearly a fifth of the companies in the S&P 500 have already warned that fourth-quarter earnings will be lower than expected.
2. The high cost of oil. Most of the economic downturns in the U.S. since the 1970s have been preceded by increases in crude oil prices. Oil prices above $80 a barrel serve as a huge tax on both consumers and businesses.
3. Money being withdrawn from the stock market. Investors withdrew $35 billion from equity mutual funds in 2011 with funds outflow for 34 of the last 35 weeks. The drumbeat of bad news, enormous volatility, and a generally flat market is scaring retail investores away from the stock market.

Thus, my expectation is that the U.S. stock market is headed downward due to declining earnings even without the occurrence of a "Lehman" like event. The wild card in predicting the direction of the stock market in January and February is the potential for a shock to the financial system due to a crisis in Europe. So much sovereign and bank debt that must be raised between now and the end of February that bid failures may be a likely outcome during the next two months. While less likely, a conflict with Iran could also roil the market.

My opinion is that shorting the U.S. market will be profitable during 2012 even if no crisis occurs. However, patience may not be required for short sales to become profitable in the event of a shock to the financial system. I expect that the S&P 50 will be at 900 by May. While it may be premature to short the market during January due to risk that the market will be able to levitate a bit longer, this short term risk is compensated for by the potential reward of a shock to the financial system occurring at some point during this month.

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