What's to worry about?  The world is engulfed in a liquidity tsunami from Japan's QE expansion to the ECB's bond buying program and the Federal Reserve's QE3.  Bond yields have fallen for Spain and Italy pulling them out of the danger zone, the flames of the Eurocrisis have died down to smoldering embers and there is a general belief that the world will somehow shortly reignite the engines of economic growth just any day now.  With October starting the seasonally strong "best months of the year" there seems to be nothing but clear sailing ahead.

Of course, as Bob Farrell's rule #9 so eloquently states "When all the experts and forecasts agree - something else is going to happen."  While the media focuses their attention on all the things that could go "right" to keep the rally going - investors should focus on the things that could possibly go "wrong" which could result in significant, unexpected, capital reductions.  Therefore, as we look forward into the final quarter of 2012 here are the three big risks that could crack the markets.

The "Fiscal Cliff"

The fiscal cliff is looming larger as we rapidly approach the end of the year.  The simultaneous collision of expiring tax cuts, automated budget and job cuts, and the implementation of 22 new, or higher, taxes from Obamacare will weigh not only the economy but the markets as well.  If Congress does not address this issue, and very soon, the fear of a jump in tax rates will induce a market liquidation as investors sell postions to realize capital gains at 2012 rates of 15% before they jump to 23.8% in 2013.  Furthermore, those investors that have been pouring money into high yielding dividend investments may begin to rethink their strategy as dividends jump from 15% to 43.4% next year.  

However, it is not just the hike in investment related taxes that will cause a burden on the markets.  The impact of the entire "fiscal cliff," should it go unchecked, will impose an estimated 4% clip to economic growth, and ultimately corporate earnings, pushing the U.S. into a deep recession next year.  The financial markets are currently pricing in strong economic growth in 2013, as high as 4%, versus the current paltry 1.25% as of Q2-2012.

Historically, stocks have lost roughly 30% of their value on average during a "normal" economic recession.  With such a wide disparity between the current price of the S&P 500 index and the underlying economic and fundamental realities - the potential reversion could be as brutal as seen during the last two recessionary cycles in 2000 and 2008.

Euro-crisis And Euro-recession

Other than a lot of promises, hope and hand shaking - there has actually been very little progress made in resolving the issues that plague the Eurozone.  While bond buying programs, monetary assistance, and continuous "talk" has kept quieted the news flow from the Eurozone in recent weeks - the debt, deficits and economic struggles still weigh on countries unwilling to implement spending controls and debt reduction programs. 

The bond buying program that has been put forth by the ECB as the solution to saving the Eurozone is really nothing more than a regurgitation of the SMP Program which was tried, and failed, in 2011.  The reality is that the program doesn't attack the root problems at the base of the Eurocrisis which is a complete lack of a constitutional union, and central banking system, under which the countries have collectively agreed to operate.  The current union is destined to fail simply due to a lack of a unified structure - "all chiefs and no indians."

However, the recession in the Eurozone is just as big of a risk to the 4th quarter as a return of the crisis.  The continued recessionary drag across the Eurozone is dampening revenues and slowing demand for exports from the U.S.  Recent corporate reports from key transportation related companies have all warned of weaker outlooks due to slowdowns in the Eurozone.    

Since the end of the last recession exports have made up roughly 40% of corporate profitability.  The chart below shows exports as a percentage of GDP.  Historically, when exports turn down the economy was slipping into recession.  The recent drop in durable goods orders and industrial production are warnings that this could already be occurring.  

While the media continues to discuss how the U.S. is faring well despite the drag from the Eurozone - the reality is that it just takes time for the slowdown across the ocean to migrate its way west.  The chart below shows the Eurozone versus the U.S. economy and the close relationship that exists between the two.  It is unlikely that the domestic economy will be able to avoid the drag of a continued recession in Europe for long.  

Earnings Slowdown

Another risk to the 4th quarter comes down to the impact of the deteriorating economic environment on corporate earnings.  Stock prices have been rising solidly over the past several months to get in front of the anticipated QE3 operation by the Fed.  However, that rise in price comes at a time without an increase in the underlying fundamentals.  This detachment of price from earnings puts the markets at risk of reversion in the months ahead.

The chart below shows Gross, EBIT and Net Profit Margins for the market.  What is clearly evident is that each has peaked and began to weaken.  Falling margins and year-over-year revenue growth (topline sales) becomes a real concern as analysts continue to estimate a sharp rise in revenue (dashed line for the last half of 2012) in the months ahead.  These overly optimistic assumptions will have to be negatively revised in the coming months given the ongoing weakness in Europe and China.

Unlike the 2008-2009 recession when revenues fell at the same time as the cost of sales - we are currently witnessing a far more disturbing development of falling gross margins in recent quarters.  This suggests, unlike the last recession, that costs are rising relative to topline growth which will rapidly impact profit margins more than currently estimated.

Not Just 3

These are just three of the risks that we see going into the 4th quarter that could well limit the impact of the recently announced QE3 bond buying program.  While the Fed may state that the program is in place to boost employment - the reality is that the program was implemented to stave off the impact of the recession that is slowly sweeping the globe.  The coordinated efforts of the ECB, Japan, China and the U.S. make this clear.

The biggest threat to the financial system is another sharp recession that could potentially lock up the financial system.  The debt burdens that currently clog the system have not been dealt with and the systemic risks are still very present throughout the system.  With economic growth faltering any shock to the system, such as the "fiscal cliff", could well be the domino that begins a sharp unwinding of the risks that have once again built up in the system.

With the current markets overbought, extended and overvalued combined with overly optimistic future expectations - the components of the next mean reversion are already in place.  The only question is what triggers the next decline?