This is a significantly revised and expanded (four times longer) version of an article preliminarily posted on Wednesday, posted now due to timeliness and excessive length. I will post articles similar to this one monitoring the economic and financial environment in the future, hopefully shorter, perhaps on a weekly basis (time permitting), please look for them, thanks.

With the global economy humming along in the first quarter, even the perennial laggards Japan and Germany are doing better than expected after a very long period of corporate restructuring, micro and macro reforms, with Japan seemingly finally exiting its deflationary environment, with commercial land prices rising 1% in Tokyo last year, not much but the first increase in more than a decade.

Although most investors wouldn't know it just looking at the major U.S. stock market averages, overall financial market euphoria is at one of the highest levels in the past twenty years, best indicated by extremely low credit spreads across the board (similar to stratospheric p/e's during the massive TMT equity bubble in the late 1990s).

It perhaps wouldn't take too much to start the mass psychology pendulum downward in the other direction (unless the pendulum flies right off in another huge speculative blow-off, as occurred at the end of 1999 and early 2000).

If normal seasonal and four-year presidential cycles still hold, then the U.S. stock market may top out in the next month or so, then decline, perhaps much more sharply then many might currently expect, into an October low. Whether a strong rally ensues from that low, as usually occurs to a high next year, would depend on the larger secular bear vs. bull debate.

Below are some of the areas that possibly could begin the speculative euphoria pendulum's downward swing in the next few months, i.e. significantly increasing risk aversion, implied volatilities and credit spreads and compressing p/e's. These are NOT predictions or forecasts of imminent, impending doom, but rather legitimate risk areas that we will continue to monitor closely for you.

A few preliminary caveats. Prospects for the real estate sector are key yet difficult to forecast since this sector is in unchartered territory in this cycle. Perhaps surprisingly because of its critical importance to the U.S. economy during this economic cycle, this sector is generally not analyzed closely enough by Wall Street equity research departments, including the macroeconomists, especially the risks posed by mortgage resets and "investor" home flippers.

And while most individual investors have good knowledge of this area based upon their own personal experience as homeowners, many becoming experts after multiple refis, they may tend to have an optimistic bias extrapolating recent experience and based upon their financial self-interest.

Three other areas critical in this cycle where equity investors could also be blind-sided are credit derivatives, emerging markets and oil prices. The first is simply a "black box" for Wall Street equity research, rarely considered, which is usually okay except when one of those "fat tail" statistical outlier credit events comes along, such as LTCM in 1998.

While emerging markets are heavily researched by Wall Street, the average equity investor should not fool himself regarding his ability to really understand what's happening in Shanghai or Bangalore as compared to Silicon Valley or Detroit. Oil is also heavily researched, but oil prices can be strongly influenced by geopolitical events that no expert can really forecast with precision.

One final initial caveat. Without the now-retired Wizard of Oz at the Fed, it should be noted that there are virtually no viable mainstream economic/political alternatives waiting in the wings right now that financial markets would have great confidence in, which could make the situation get much worse much more quickly than expected should things start to unravel.

While the global real economy still seems strong, there are wild cards in the deck as the hands are dealt out. Here are some of them.

Economic and Financial Risks

Real estate: According to today's WSJ, "New-home sales recorded the steepest drop in nearly nine years during February, marking the fourth decline in six months ... The level of demand was the lowest since May 2003 ... There [was] a 6.3 months supply at the current sales rate and the highest inventory level since January 1996's 6.4 months supply," up from 5.3 months this January." The median sales price was down 2.9% from a year ago.

The previous day, existing home sales were reported to be surprisingly strong in February, the largest percentage gain in two years, partly attributed to the effects of unusually warm weather in January, after declining 9% in the prior five months, with 5.3 months of supply. Sales have fallen by double-digit percentage in some of the hottest markets, but may be heating up in some of the most affordable ones.

In general, prices have been modestly declining since last summer; inventories are rising; and purchase mortgage applications are off, 16% in the last twelve months, 26% in the last week from the peak in June. An index of home builder sentiment is the lowest in three years. Buyers and sellers have seemed to be in a stand off, who is in denial should be more clearly evident this spring selling season.

According to a recent report (see my 3/21 "FHPN Real estate slowdown, Spring clearer look at fundamentals, speculative psychology tipping point" link), 71 U.S. housing markets were "extremely overvalued" at year's end, with 18 of 20 of the most overvalued markets in California and Florida.

Key issues in these extremely overvalued markets would include how long speculative "investor" flippers and sub-prime, adjustable-rate mortgage borrowers will hold on before panic selling starts to begin. In the Midwest, weak industrial employment is already taking its toll. Foreclosures in several key states there and Georgia are now at their highest levels since the 1979 Iran oil crisis

Since there never has been this much real estate speculative activity and so many questionable mortgages to less creditworthy borrowers, no one really knows the riskiness of the situation. One study recently concluded that about one million households would eventually foreclose in the next few years, assuming current levels of home prices and interest rates. A recent poll indicated that more than one-quarter of holders of adjustable rate mortgages aren't sure if they can make their payments if interest rates go up.

One thing seems fairly certain, expectations are way too high if home prices continue not to rise, and the dashing of them would start to have self-fulfilling negative consequences. In a recent survey cited in my 3/21 FHPN only 5% expected no increase in the next three years.

Even with flat prices, with consumer debt servicing now rising faster than disposable income due to both rising debt and rising interest rates, and the home equity ATM significantly declining due to flattening home prices, it would only seem to be a matter of time before consumer "shop til you drop" mentality finally starts to get reined in.

Despite all the stories summarized in my latest real estate FHPN referenced above, as to whether there is a real estate bubble, in the final analysis I still basically go with my gut. This worked well in the TMT equity bubble. Back then, how could anyone look at literally hundreds of new companies going public that were hemorrhaging red ink, without experienced management teams nor even viable business plans, and claim with a straight face, as the Fed would do, that it couldn't tell if there was a huge bubble.

Similarly, my gut simply tells me that there is no way that a non-income producing asset, a small, fifty-year old run-down ranch house on a slab foundation on a postage stamp lot on a dreary treeless sun-baked street, in a region which has seen employment decline about 20% in the past five years, Silicon Valley, is really worth $700,000 or more.

This is an extreme example in a state that is notorious for its anti-development bias which greatly limits the supply of new housing. Nevertheless, given the huge price increases in so many highly speculative markets over the past five years or so, can anyone, including Fed governors, seriously say with a straight face that there isn't a bubble, and thus that the purchasing power and store of value of the dollar plummeted over that time due to massive credit excess?

What isn't clear to me at all, or seemingly to anyone else as far as I can tell, is how long a situation can continue where people adamantly refuse to believe what their eyes and simple common sense seem to tell them because of their bank accounts.

Corporate capex: Especially if real estate slows more rapidly than consensus, at what point does Global 1000 use its record cash flow and profit margins to stop trying to buy growth and competitive position through m&a, often frittered away to the immense benefit of the i-banks and private equity funds, and actually start to more heavily re-invest, as in a more normal business cycle, in new p&e, r&d, employment, etc.

The consensus expects corporate capex to pick up the slack if the consumer starts to, finally, slow. What if the consensus is wrong?

I mentioned above that I rely on gut feel when it comes to the real estate bubble issue. But I much prefer a more objective approach. When it comes to economic forecasts, my favorite tool is leading indicators. The Economic Cycle Research Institute, ECRI, does an excellent job producing and interpreting real-time leading economic indicators. According to a March 1 Reuters story:

""An industrial slowdown could come when consumer spending growth is already slowing, resulting in much weaker overall growth than generally anticipated this year," said Lakshman Achuthan, ECRI managing director ... ECRI argues that may be more of a last gasp for manufacturing in the current economic cycle then the start of a sustainable upward trend in activity. "The not-too-hot, not-too-cold 'Goldilocks' economy envisaged by many economists could turn out to be a mirage," said Achuthan ... "The correction in metals prices appears to be in line with earlier signals of a cyclical slowdown in the industrial sector, and may thus be the early stage of a cyclical downswing rather than just 'noise,'" Achuthan said."

Oil: Price could spike up on bad news on supply disruptions from Mideast, etc., or start to decline due to rising inventories and demand growing slower than global economies. While the second scenario would seem to be positive for the economy, energy stocks tend to be late cyclical.

If that cyclical relationship continues, and some would argue that it's changed due to an increase in secular demand from China and other developing economies, then a topping in this sector would be a sign of a stock market top. If the oil sector, strongest in terms of profits and stock price increases for more than two years, starts to top out, what would replace it?

We can't go into here the issue of whether or not "Peak Oil" will be soon, or already is, upon us, but suffice it to say that there is seemingly legitimate uncertainty regarding the size of global oil reserves and the prospects for greatly increasing them.

Bond prices: yields on 2-, 5-, 10-year bonds are right at 10-year down trendlines. If yields decisively break upward, real estate market assumptions of "soft landing" will start to tip to "hard," tipping everything else in the process too. Spikes in bond yields have been common early in the year the past 5-6 years, so it's still too early to tell this year.

Central bank tightening and yield curve: Will Bernanke over or under-shoot and stop at 5%, 5.5%, does he even know what target he's shooting at? For the first time in a long time, all three of the largest developed region central banks are simultaneously tightening, will they overdo it, or will the Fed end sooner than expected well before the others? Are Asian central banks behind inflation in their growing economies, and will they have to play catch up in raising rates?

The bottom line is how restrictive are credit conditions. Those with a bullish bias would maintain that monetary conditions and excess liquidity are still quite loose even while the Fed has now re-loaded its liquidity weapon and can once again cut rates, should the need arise. Those with the opposite bias point out that flat or inverting yield curves have signaled recessions in similar low-rate environments in the past, and that the stock market usually performs poorly after the final Fed tightening.

In an era of deregulated global capital markets, how much does the Fed and other central banks really control the hyper speculative expansion of credit in the first place? I.e., who is really driving the bus, the global speculative financial entities or the supposedly now "independent" central banks ostensibly chartered in the public interest?

Earnings estimate and profit margins: Consensus estimates actually show a significant acceleration of earnings growth in the second half of 2006, especially a very large one from already high growth for small cap stocks, which seems overly optimistic, since record-high margins don't seem to have further room for significant expansion. We will have more to say on this issue in coming weeks as we approach first-quarter earnings reporting season.

Emerging markets: The center of gravity of the global economy is shifting dramatically away from the slow-growth developed economies to the fast-growth developing ones, especially in east and south Asia. But charts of equity price rises in emerging markets, including those in eastern Europe and Latin America, along with the EEM ETF are beginning to bear a familiar resemblance to the TMT equity bubble of late 1990s, flying way beyond normal upside standard deviations. One might argue with the analogy on the grounds of valuation (emerging market forward p/e's are lower than developed markets), trend sustainability and even historical significance of the respective changes.

Nevertheless the euphoric mood seems in high gear despite a March sell-off, with more mutual fund inflows in this sector so far this year than all of last yea. Russia's economic minister openly worried about a stock market bubble in his country, but nobody seems to care (see my 3/6 "FHPN Real estate slowdown, emerging markets risks" link). Any slowdown in China, the U.S., and/or energy prices could significantly take some of the air out of these sails, and other regions may join the Persian Gulf, which may have seen its stock bubble just burst.

China export and consumption growth: If the U.S. slows in the second half, is China export and investment growth sufficiently less dependent on the U.S. and now enough on intra-Asia, and if China export growth does slow, will its domestic consumption growth pick up the slack fast enough? Would the improved economic prospects for Europe and Japan, the latter surprisingly stronger than expected recently, be enough to make up for the slowing of the twin engines of global economic growth the past few years, the U.S. consumption and Chinese investment booms. As with profit margins, we will have more on this area shortly.

Credit derivatives and carry trades: Financial excesses in this credit cycle are concentrated and hidden in these huge but highly opaque private financial markets (unlike equity markets, which are public and highly regulated) which are being roiled by GM, once again, and Bank of Japan and Fed.

Because hedge funds and other hot money have so heavily piled into the same trades chasing yield, it might take surprisingly very little to disrupt the current fragile equilibrium euphoria. NY Fed Pres Geithner, others have expressed concerns (see upcoming FHPN on this issue).

As with the LTCM disaster in Sep-Oct 1998, this is a wild-card because only insiders can really see a looming disaster, and scramble to try to get out of harm's way and/or take advantage. Due to the opacity of the private transactions, the last to know will be the more rabid bulls in the public equity markets.

Yet as with LTCM, the insiders take on huge leverage expecting to be bailed out by the Fed due to the "too big to fail" syndrome, creating immense and immoral "moral hazard" of public insurance for huge private gains by the most wealthy, with virtually no economic benefit in supporting sheer speculation.

Global macro imbalances: The U.S. current account deficit was 7% of GDP in the 4th quarter, currently being net financed solely by purchases low-yielding fixed income securities, and is expected to get even larger this year. In the past most economies started to experience financial distress at around 5%, so how much extra leeway does the putative "sole superpower" continue to get?

Despite all the cries of wolf by highly-regarded experts that have been wrong so far (in terms of economic timing, not morality), this can't go on forever like this, despite what the "Bretton Woods II" and "dark matter" camp believes, there must be some credible limit eventually established, so far there isn't.

U.S. fiscal deficit: Ditto, at some point there must be a credible plan to stop the red ink from flowing to infinity into the baby boomer retirement horizon. So far there isn't.

Rubin, Volcker, Peterson, Concord Coalition faction of "enlightened capitalists" have made no headway on the issue, lacking a political vehicle to do so, their austerity program would not go over well anyway with electorate tired of no longer credible call for "shared sacrifices" that never materialize for the haves and the have-mores, as Bush once described his wealthy base.

Banks: Still looking strong right now, especially the i-banks with record profits, but what if some of the above start to occur, then what happens to U.S. corporate profits highly dependent on financial giants (see my 3/15 "FHPN Goldman profit, US trade deficit both records, end-result of 30-year rise of speculative finance" link).

Dollar: Finally, but perhaps ultimately most importantly, at what point do U.S. foreign creditors, who currently hold $11.1 trillion of U.S. assets (heavily skewed, especially by Asia, to low-yielding fixed income securities), look at all of the above and say the dollar's positive interest rate differential isn't worth it, let's diversify away from the dollar, better to take the hit to our bloated dollar reserves sooner rather than later?

Increased strength in other major economies, e.g. Japan and Germany, could lower the relative attractiveness of U.S. growth. Productivity trend growth in the U.S. may be about to start slowing, just as it is improving further in Japan and perhaps even in Europe. Lower home bias, i.e. the willingness of foreigners to invest abroad, has greatly helped the U.S. dollar, what if this starts to reverse.

Especially if the geopolitical stuff below, such as in the Mideast or friction with China, starts to really go against the U.S., and a Eurasian "balancing coalition" starts to form, around national and energy security issues, against the sole U.S. "superpower" hegemon, then "feedback loops" with the above areas could accelerate. E.g. having to raise interest rates, which would further jeopardize the real estate market, thus consumer spending, thus capex spending, starting a downward spiral in the dollar.

Geopolitical and Other Systemic Risks

Iraq, Iran, Syria, N. Korea, etc.: This also can't go on forever, despite what the neocons believe. Iraq either tips into a full scale civil war, totally destabilizing this critical region in one of the biggest U.S. foreign policy disasters ever, driving oil prices much higher, or some actual, real, credible good news starts to come out of Iraq. Ditto for Iran. Ditto for N. Korea.

Multilateralist faction of "enlightened capitalists" have offered no viable alternatives, and don't have a political vehicle, with Hillary, other centrist Clinton Dem's trying to out-Cheney Bush in Iraq. Most multilateralists don't seriously address the fact that the rest of the world is mainly pre-occupied with economic development and does not buy the U.S. agenda that the "war on terror" is priority number one, and the spread of democracy two.

China, protectionism: The protectionist drums are beating in Congress on China's trade and currency. Pressure will mount for something to happen on Hu's U.S. state visit to placate the pols grandstanding for November elections. It's not likely, then what, a new Smoot-Hawley 1930 tariff? Then how would Walmart fill its aisles with all that stuff from China? And it's not nice to lecture one of your two largest creditors, try that with your credit card company (see 3/18 "FHPN Rice tells China what it "needs to," "should" do, tone doesn't seem to be going over well in Asia" link).

Global inequality: A critical underlying factor behind most geopolitical problems, not fully appreciated in the U.S. because "class war" is a taboo topic in corporate mass media, mainstream American politics, among U.S. elite (except Buffett, who honestly said his class was winning a couple of years ago). U.S. reaching "Gilded Age" extremes, sooner or later, with real wages stagnant past five years (down 17% since 1972, see Table B-47, pg 338, "2006 Economic Report of the President," link), home equity ATM has been only thing maintaining U.S. living standards.

Once again, there is no viable mainstream alternative being offered, with the Dem's still mainly peddling discredited "funeral insurance" of re-training and yet more education (see 3/20 "FHPN Huge income inequality due to 30-year rise of speculative finance, not just to education levels" link).

This is a huge global issue, with most of the stress, and potential resistance, to rising global inequality having moved offshore, along with the factories, i.e. Walmart temp workers with no benefits aren't going to risk their jobs for dubious chance at change. E.g. China trying to defuse escalating political tensions over rising inequality, local corruption; populist governments recently elected in Latin America; the immigration issue in many countries, including the U.S.; etc.

Terrorism, proliferation of wmd, civil wars, crime such as kidnapping, trade in drugs, weapons, people, money laundering, piracy, etc., etc.: For now, I will just lump all these together, I may separate them out later, as signs of massive breakdowns of civil society and political authority due to socio-economic stresses, including population growth in poor countries. The standard developed world response so far has been to try to ignore the problems, deal with their symptoms, or try to wall them out, physically and psychologically, rather than deal with the huge costs of the underlying causes.

Another terrorist shoe could always drop, with "24" tv show type response now that Patriot Act has been renewed, little resistance to warrantless wiretaps, and the Supreme Court packed with those supporting the Bush/Cheney view of extremely expansive executive powers. However, if another very large shoe never does drop, then history might record that the Bush Admin's nearly obsessive political focus with the "war on terror" distracted the U.S. from dealing with critical, but seemingly to it less pressing at the time, problems, paving the way for the unexpected long-term decline of the putative "sole superpower."

China, Taiwan: Taiwan President recently tweaked China's nose yet once again, what if he pushes the "dragon," "big brother" just a little too much. U.S. public completely unaware of historical, political, psychological importance of this issue for China, Communist Party and PLA military, which can't and won't back down if push ever comes to shove (see 3/13 "FHPN China, India, U.S." link). Any large political and/or military confrontation would have the potential to drastically disrupt global manufacturing supply chains.

Bird flu: Human death toll now past 100, when would panic start setting in, impacting affected economies on a much larger scale than SARS. The worst case scenarios that have been publicized by the WHO would result in historic levels of death and illness and, needless to say, wreak havoc with the global economy.

This risk is just one symptom of the persistent threat caused by massive underinvestment in global health care, nutrition, clean water, sustainable agriculture, etc. Africa, in particular, has already paid a huge price from AIDS and other diseases, genocide, famine, etc., while malnutrition leading to permanent human developmental damage is actually most widespread in south Asia.

The West willfully ignoring these tragedies encompassing hundreds of millions, even billions, of people, will probably eventually be considered one of the historic great moral crimes of this era, the other being willfully risking perhaps irreversible damage to the biosphere to maintain current carbon fuel lifestyle consumption, on a far greater scale than most other crimes currently viewed that way, imho.

While most of the developed world can continue to essentially ignore all this, with a few well-meaning but effectively futile gestures, it may come back to more directly haunt it someday.

Environmental degradation and global warming: Both are very real, the former especially in the most rapidly industrializing, urbanizing developing countries, the latter in new studies showing much more rapid than expected melting of ice near both poles (see 3/14 "FHPN Evidence of climate change faster than modeled mounts from Arctic, Antarctica, Greenland" link).

At some point the huge unaccounted for costs of these "externalities" will need to be paid, that burden is increasingly and unfairly being passed to future generations by the current "shop til you drop" mindset.

Demographic timebombs: In the U.S. the large baby boom population starts to hit retirement age in a couple of years. Other developed nations are starting to age much more rapidly than the U.S., some (e.g. Japan, Italy) will even experience declining populations.

Again, retirement costs are increasingly and unfairly being passed to future generations by the current "shop til you drop" mindset, which will eventually generate a strong political counter-reaction (see 3/16 "FHPN Krugman's NYRB long essay, "The Health Care Crisis and What to do About It, "brief excerpt" link).