Happy holidays, but be worried about global risks

The year end rally has been strong. It's not all surprising given the steady climb in auto and other retail sales. Consumers maybe back from more than two years of belt-tightening. That's a big deal.

Retail investors may be tip-toeing back to equity markets as well, moving away from bond funds as the long-term rates are rising.

Institutional investors may be pushing the winners all the way to the end of December. We don't know. But given the predominately bullish commentaries we read everywhere, there is a great likelihood the market is setting itself up for a big correction comes January.

Here is an interesting indicator of the extreme bullishness.

Banks and other financials may be in a good position to benefit from the firmer recovery undergirded by the Fed's QE2 and the Congress's tax deduction extension. We have benefited a great deal from our large positions in WFC, BAC, USB, and some home builders.

But, this is the time to be very cautious. Dark clouds are swirling, people just don't talk about them much. European debt crisis is very much alive and not going away anytime soon. US unemployment rate will be elevated for years to come. Deficit problem is not been tackled in any systematic way. China's inflation problem may require much more severe measures than expected. These are known problems. Granted, market's tolerance is higher when these problems are known. Still, it seems very likely that more surprises may be lurking around the corner.

Andy Xie, an independent economist, has this piece about US and China. His main point:

China may have won the last race. To win the next one, China must tackle its inflation problem, which is ultimately a political and structural issue, in 2011. If China does, the U.S. will again be the cause for the next global crisis. China will suffer from declining exports but benefit from lower oil prices.

On the other hand, if China has a hard landing, the U.S.’s trade deficit can drop dramatically, maybe by 50%, due to lower import prices. It would boost the dollar’s value and bring down the U.S.’s Treasury yield. The U.S. can have lower financing costs and lower expenditures. The combination allows the U.S. to enjoy a period of good growth.

One could describe the global economy as a race between the U.S. and China, to see who goes down first.

We're now 50% cash, increased our shorts. We'll be even more defensive if the market continues to rally next week.