In my most recent report, I wrote about how when market sentiment stretches too far toward excessive optimism, the market can become more vulnerable to bad news.

Although much of the domestic economic news has been of the good variety, the market has had much to contend with:

• The European debt crisis, lately afflicting Ireland.
• Monetary tightening in China.
• North Korea's artillery attack on its southern neighbor.
• FBI raids on a couple of well-known hedge funds for possible insider trading.

"Wall of worry" comes back
It's not difficult to argue these were sufficient-enough pressures to inflict some damage even if sentiment wasn't stretched. What's been remarkable is the rapidity with which sentiment excesses were pared back along with the correction that, as of this writing, has shaved about 4% off the S&P 500® index.

In my last report, I noted the steep ascent of bullishness as measured by the American Association of Individual Investors poll and why this posed a risk for the market. We quickly saw that risk become a reality. Immediately following that jump to 60% bullishness, though (as you can see in the chart below), we witnessed a sharp 30% drop to only 40% bullishness, a relatively rare decline of that magnitude.

Bullishness Less Excessive

Click to enlarge
Source: American Association of Individual Investors (AAII) and FactSet, as of November 19, 2010.

Typically, after a steep drop in bullishness, the market finds its legs before too long. What it does highlight (and you can see how it's been fairly prevalent since the market's low in March 2009) is that the wall of worry—rising stock prices in the face of negative uncertainties—has come back with a vengeance with any bad news. As long as we don't lose that wall of worry, the market will likely do its contrarian thing and defy the skeptics … though maybe not quite yet.

I'm going to summarize my thoughts on global concerns, but you can also read more from Michelle Gibley both in her Market Insight articles, as well as within our Schwab Market Perspective.

China and North Korea
I've heard from many investors that they're concerned about a boom/bust scenario with all the makings of a classic bubble.

We have a more sanguine view:

• China's latest tightening was of reserve requirements for banks, with the goal of reducing banks' excess reserves that could pour into the financial system and create asset bubbles.
• Bank Credit Analyst's (BCA) China strategists believe there's little risk of a draconian policy tightening given that the cycle started from a very stimulative point.
• China's tightening is also targeted at real-estate speculation and not the overall economy. 
• Although commodity inflation is heating up, core inflation in China remains well-contained because higher commodity prices are not feeding into end goods and services.

China will also likely be a key player in eliminating the risk of a second Korean War. In its interest to keep a rash of North Koreans from immigrating into China, the Chinese government has been relatively supportive of the current regime. But the government did call a meeting during the weekend to ease tensions and is rushing to establish some new ground rules for North Korea in the face of global criticism.

European Financial Stability Facility is launched
It doesn't appear the North Korean attack will have lingering implications for the world economy or global stability.

Ireland is a different story and represents yet another of the rolling debt crises afflicting the euro-zone. Apparently, everyone took out their credit cards this weekend. The International Monetary Fund and European Union (EU) put together a $113 billion bailout package for Ireland, representing about 60% of its gross domestic product (GDP). 

But the concerns about meeting debt obligations extend to Spain, Portugal and, yet again, Greece. Fortunately, Greece, Ireland and Portugal account for only 6% of the euro-zone's economy.

One interesting development was the comment made by Axel Weber, the head of Germany's Bundesbank. He's a member of the European Central Bank (ECB) Governing Council, and rumored to be the next president of the ECB after Jean-Claude Trichet's term is complete. 

Weber mentioned that the EU's bailout fund could be increased if necessary to restore confidence in the euro. In fact, there's a growing camp that believes the ECB may eventually unleash its own new round of quantitative easing by purchasing a big chunk of European sovereign debt. (Our Federal Reserve recently announced QE2—a policy injecting cash into the economy and pushing interest rates lower by purchasing Treasury securities.)

Also, the Council of the EU set up a European Stabilization Mechanism slated to go into effect mid-2013 to replace the bailout fund it established in May. The key to this plan is for future debt crises to be handled on a case-by-case basis, rather than abiding by automatic mechanisms.

There's a rub here, though: Following the announcement of an Irish rescue plan, investors simply turned their attention to which country is next in line, with Spain being the elephant in the room.

Where exposure lies
The overarching concern is not related to the impact on the global economy, considering Ireland is a small economy, but is about the prospect of a sovereign debt default and consequent damage to the European banking system.

In terms of where exposure is greatest, BCA recently crunched the numbers and found that European banks are the largest holders of the debt of the four troubled borrowers (Ireland, Spain, Portugal and Greece).

Specifically, German banks have the largest exposure to Ireland. The good news is that US banks actually have very limited exposure. You can see the details in the table below.

Consolidated Foreign Claims of Banks

	Percent of total assets
	France	Germany	Italy	Japan	UK	United States
Exposure to:
Greece	0.49	0.37	0.10	0.02	0.20	0.06
Ireland	0.46	1.41	0.29	0.28	2.54	0.57
Portugal	0.39	0.38	0.09	0.02	0.38	0.03
Spain	1.49	1.84	0.48	0.22	1.89	0.39
Total	2.83	4.00	0.96	0.54	5.01	1.05

Source: BCA Research, Inc., as of June 30, 2010.

Were problems to significantly accelerate in Spain, the implications would be more severe and the future of the euro currency would be called into question. But BCA believes the situation is not spinning out of control.

Spain's debt-to-GDP ratio will be about 63% in 2010, lower than even Germany's. Spain's budget deficit is shrinking and its authorities have taken serious measures to please the financial markets. Given Spain's problem being about private borrowing and not public-sector debt, the key will be to prevent a US-like crisis in real estate.

Trade impact
I've gotten many questions lately about the mechanism of trade and whether problems in the euro-zone will significantly damage US exports to the region. As noted by High Frequency Economics (HFE), absent a fundamental meltdown in the euro-zone, trade is the key mechanism to transmit economic activity from one country or currency zone to another.

The trade linkages between the United States and the euro-zone are limited. The euro-zone accounts for about 14% of exported US goods. With total exports representing only 12.6% of US GDP, HFE calculates that even if exports to the euro-zone were to fall by 50% (highly unlikely), US GDP would be hit by a mere 0.9%.

Dollar strength = market weakness?
All of the issues above have kept significant pressure on the euro, while elevating the dollar during the past couple of weeks. This is in stark contrast to investor expectations after the Fed initiated its second round of quantitative easing.

The stronger dollar has also contributed to the weakness in stocks and commodities given the inverse correlations between the dollar and both. We don't believe the inverse correlation between the dollar and stocks is a permanent fixture, but it's with us for now. Historically, more often than not, the two are positively correlated, as you can see in the table below.

S&P 500 Performance During Dollar Bull and Bear Markets
Dollar bull/bear	Dates	Days	US Dollar Index % change	S&P 500 % change
Bull	07/06/1973-01/23/1974	201	20.9	-4.2
Bear	01/23/1974-10/30/1978	1,741	-25.1	-2.1
Bull	10/30/1978-02/25/1985	2,310	100.7	88.5
Bear	02/25/1985-12/31/1987	1,039	-48.2	37.9
Bull	12/31/1987-06/14/1989	531	23..7	31.1
Bear	06/14/1989-02/11/1991	607	-23.8	13.8
Bull	02/11/1991-07/05/2001	3,797	50.2	230.8
Bear	07/05/2001-04/22/2008	2,483	-41.0	12.9
Bull	04/22/2008-03/05/2009	317	24.9	-50.4
Bear	03/05/2009-11/25/2009	265	-16.7	62.7
Bull	11/25/2009-06/07/2010	194	19.0	-5.4
Average dollar bear market			39.9	48.4
Average dollar bull market			-31.0	25.0
Recent decline	06/07/2010-11/04/2010	150	-14.2	16.2
Recent rally	11/04/2010-11/26/2010	22	6.6	-2.6

Source: Bespoke Investment Group (B.I.G.), Bloomberg, and FactSet, as of November 26, 2010. 

US economy gaining traction
It's our view that part of the reason for recent strength in the dollar is the improved outlook for the economy. The latest revision to GDP for the third quarter of 2010 was a better-than-expected 2.5%, while economists' estimates for the fourth quarter of 2010 are heading higher.

Initial unemployment claims—the best leading indicator for payroll growth—recently (and substantially) broke out on the downside. More broadly, the leading economic indicators are rebounding after a summer lull and improving job growth should give a boost to the coincident indicators, as well.

Even consumer spending has been ahead of expectations for five straight months and the holiday shopping season is shaping up nicely. The initial read on the Thanksgiving weekend's sales tally was a jump of more than 6% from last year, without the recent bias toward the discounters. In fact, real (inflation-adjusted) consumer spending is now officially in "expansion" mode given that it has surpassed the 2007 peak. You can see this in the chart below.

Consumer Spending in Expansion Mode
 
Click to enlarge
Source: Bureau of Economic Analysis and FactSet, as of October 31, 2010.

Many point out that a lot of the lift has come courtesy of stimulus-related transfer payments from the government, but do note that, more recently, both hours worked and real wages/salaries have been accelerating.

Business confidence is recovering and should lead to increased capital spending and job creation. As to the former, recent Fed data showed an increase in commercial and industrial lending for the eighth week in 11. Even consumer loan fundamentals are shaping up as lending standards across the spectrum of loan type have eased significantly. Loan demand, though, will remain shy of supply as long as the private sector continues deleveraging (paying down debt).

Debt woes will linger for a long, long time
Deleveraging cycles take a very long time, whether they're of the private or public-sector variety. We're still in the early stages. I would have a less sanguine view of the problems in Europe if we weren't seeing some renewed economic strength in the United States. Ultimately, we believe it's those fundamentals that will hold sway over Europe's sovereign debt crisis, but the period of digestion for the market may not yet be past.

Important Disclosures

The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The MSCI Emerging Markets IndexSM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

The S&P 500® index is an index of widely traded stocks.

Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Past performance is no guarantee of future results.

Investing in sectors may involve a greater degree of risk than investments with broader diversification.

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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