Dubai's debt problems rattled markets over the holiday. Can favorable conditions persist, or will bad news stir the bears? Beware a dollar rally
Stocks are in a final sprint toward the end of 2009. After nine months of favorable market conditions, equity investors face a further month before they can declare victory in 2009. The flip of the calendar may be arbitrary, but the full year is the standard by which mutual funds, hedge funds, and other stock investors are judged on their performance. Investors could be forgiven for wishing that 2009 would end placidly and profitably. But there's one thing that the past couple of years have taught us about the market: Expect the unexpected. Dubai's debt troubles, which came to a head on Nov. 25, when the emirate's investing arm said it was seeking to delay payments on $59 billion in debt, disrupted a growing confidence among investors. Until the news broke over the Thanksgiving holiday, it looked as if markets might glide easily toward the new year. It has been a quiet couple of months on Wall Street. "We are seeing some signs of normalcy," says Erik Davidson, managing director of investments for Wells Fargo Private Bank. Since the end of September, the broad Standard & Poor's index of 500 stocks is up 3.3%. Volatility is down. Although the market has risen and fallen day by day, the ride has not been bumpy. From its October starting point, the S&P 500 has never varied by more than 5% to the upside or 3% to the downside. The S&P 500 has jumped 60% since its low in March. The turbulence in Dubai spread quickly because it raised questions about two important pillars of that rally—improving strength in the financial sector and credit markets and the resilience of the global economy, particularly in emerging markets. Dubai's woes: Just a local issue?
The true depths of Dubai's financial difficulties remain unclear. Investors appeared concerned but not overly alarmed. At one point on Nov. 27, the S&P 500 had dipped 2.4%, but the stocks battled back and the index closed down 1.7%. Market participants' worries may have been eased by assertions that Dubai's problems were a local issue. "The current troubles being seen in Dubai are a direct result of its efforts to tie its fortunes to global real estate, tourism, and services," Brown Brothers Harriman currency strategist Win Thin wrote on Nov. 27. They "are particularly unique to Dubai and should not have wider implications for [risk to other emerging market sovereign debt]." But many questions remain unanswered. UBS (UBS) analyst Saud Masud suggested one explanation of Dubai's surprise move to postpone debt: Its debt may be higher than the $80 to $90 billion that many assume. But, Masud says, the restructuring of "Dubai Inc." could have positive benefits. "While this process will be painful and will take time, it should put Dubai on a sounder footing medium term," Masud wrote on Nov. 26. Experienced investors know that news such as that from Dubai can easily jeopardize the market's recovery. There is always the danger of an "exogenous shock"—whether it's a geopolitical event or a market surprise—that could send investors fleeing risk toward safer investments. "There is always the danger of a correction," says Quincy Krosby, Prudential Financial (PRU) market strategist. "That can happen any time at any place." the dreaded "double-dip" recession
At the moment, the most disruptive scenario could be a rapid strengthening of the U.S. dollar, Krosby says. That could unwind the so-called "carry trade," in which investors have been taking advantage of low U.S. interest rates to borrow and then buy risky assets both in the U.S. and abroad. Despite the threats, investors still have reason to hope that the year will end quietly. Economic data have steadily improved, a trend that should continue for a while. "All the economic data [point] to continued growth," says Peter Cardillo, chief market economist at Avalon Partners. He is increasingly confident that the U.S. can avoid a "double-dip" recession. One test could be how willing U.S. consumers are to spend this holiday season, which officially began on Nov. 27's so-called "Black Friday." Stifel Nicholas (SF) analysts visited retailers on Nov. 27 and offered initially positive reviews. "We believe sales are meeting or exceeding [the] plan for Black Friday," they said. For holiday spending, "expectations are set so low," says Davidson of Wells Fargo. "If anything, the surprise of the holiday season could be to the upside." So far in 2009, the Dow Jones industrial average has advanced 17.5%, while the S&P 500 has risen 21% and the tech-heavy Nasdaq composite is up 35.6%. As Davidson notes, the S&P 500 is now almost perfectly halfway between its October 2007 peak of 1,565 and its March 2009 low of 676.53. As investors waver between optimism and pessimism, the question they must answer in the months to come is whether that means the market is half-full or half-empty.