Chill Winds Confront U.S. Stocks

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Joy sees a disconnect in attitudes toward the market on Wall Street and Main Street. "The memory of the pain of the last 12 months is still very raw in the minds of individual investors [while] Wall Street has the ability to put the past behind it because [the attitude is] 'We have to keep moving forward,'" he says.

Headwind #3: A Dwindling Stimulus

With much of credit for the nascent signs of economic recovery being given to government stimulus programs, there's a lot of trepidation about what will happen once the Federal Reserve starts to reverse its extremely accommodative monetary policy.

Investors are waiting for the Fed's policy committee meeting in early November to see if Ben Bernanke and his cohorts say anything that shows the recovery is far enough along to warrant the withdrawal of some liquidity that's been pushed into the financial system, says Joy at RiverSource.

"There's good reason to believe that if the Fed hikes rates, it believes the recovery has taken root," says Chadha at Deutsche Bank. He cites the equity rallies around the world that greeted the Australian central bank's rate hike earlier this month. (However, a rate hike by Norway's central bank may have factored into global equity weakness on Oct. 28.)

"The question is why the Fed is hiking rates? If it's because of an immediate inflation threat, that may not be good for equities, but we don't see that right now," Chadha says.

There's talk in the market that the Fed could raise interest rates as early as the spring, and that's definitely a concern, says Detrick at Schaeffers. That could hurt small- and mid-cap companies, which are least equipped to handle the increased cost of borrowing, he says.

"You need small-cap leadership for a bull market. It shows you appetite for risk is strong," he says. "Small caps and tech names led on the way up and are now are leading on the way down."

Headwind #4: Reduced Access to Credit

While earnings may have surprised on the upside this quarter, the outlook for ongoing growth in corporate earnings doesn't look good if American households—which drive 70% of GDP—have less access to credit in the years ahead.

"Any [corporate] business model or investment model or consumption model that was predicated on cheap, accessible credit is going to be challenged" from now on, says Stephen Wood, chief market strategist at Russell Investments in New York.

Although the credit markets have recovered significantly, it would be very unrealistic to expect credit flows and financing to return to 2006 levels, he says.

Headwind #5: A Stronger Dollar

While the trend in the greenback continues to be lower, more and more investors now believe the dollar may be fairly valued relative to the currencies of the U.S.'s major trading partners, suggesting it could rally from here, says Joy.

A stronger dollar would put a damper on U.S. stocks because it would make U.S. companies' exports less competitive and reduce future earnings. And with an estimated 40% of total revenues generated by companies in the S&P 500 index coming from overseas, a stronger dollar would make it less profitable to repatriate a lot of those revenues into dollars, he says.

But it would also work against banks and other institutions that have borrowed cheaply in dollars and reinvested in higher-yielding assets such as foreign currencies. That could hurt investor appetite for financial stocks. There's also the possibility that the dollar could rally in a further flight to safety if a major setback rocks the global economy.

Bonus Headwinds

Besides these five factors, investors are also likely hesitant because economic data are looking more mixed than they did a couple of weeks ago. This week consumer confidence dropped for a second consecutive month. Mortgage applications were down 16% in September. There's also concern around pending regulatory-reform legislation that could adversely affect the health-care and financial sectors.

Even if the general outlook on stocks stays positive, it's unlikely to be a tide that lifts all boats, unlike that of the past seven months.

"We're moving into an environment that speaks for active management [of equity allocations]," says Wood at Russell Investments. "Not every company is going to be able to transition from an earnings gain into a revenue gain," since cost cuts have been the main factor behind better than expected profits.

Wood expects investors to start to discriminate more between companies that can drive sales higher and possibly even raise prices in 2010 and those that can't.

Bogoslaw is a reporter for BusinessWeek's Investing channel.

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