A credit contraction is well underway, oil remains near its all-time high, the housing free-fall is accelerating, and central bankers are freaking out. So, who would have predicted that the Dow would reach an all-time high in October and still hover within about 6% of that number as the year drew to a close? Or that the corporate bond default rate would close the year at or near an all-time low?

Me neither!

The market’s relative buoyancy reveals a touching faith in the powers of the Fed and other father figures of the financial landscape. Will this faith remain strong enough to surmount the tests that lie ahead? Before answering, ponder upon some thoughts from the Ghost of Christmas 2008:

• With equity-free (not to mention upside-down) homes proliferating across the country, consumers turn to their retirement accounts and credit cards to keep afloat. This stop-gap proves very short-term, and consumer credit takes a trip down the subprime path.
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• The rush to sovereign wealth funds for rescue money slows dramatically as politicians and the public push back, alarmed about foreign government interference and the prospect of a Dr. Evil gaining access to American technology.
  
  
• Xenophobia, economic stress, and – this is a sure thing – pandering politicians lead to resurgent protectionism. The march towards legislation is interrupted, however, as international investors remind politicians that the U.S. now works for them.
  
  
• Counterparty risk moves to the foreground as banks and institutions discover that those companies from whom they bought CDS and other types of insurance were just kidding about their capital reserves.
  
  
• The pendulum swing away from libertarianism and towards a more positive view of government and regulation accelerates as insolvent consumers and companies clamor for safety nets and bail-outs. Investors, scorched by hundreds of billions in losses on trillions in asset-backed securities and derivatives, urge regulators to slam shut barn doors across the financial landscape. With structured finance stuck in the penalty box, CDO-financed lending diminishes to a trickle.

• A dollar crisis forces the Fed to halt interest rate cuts even as the economy moves deeper into recession (yes, the recession has already begun).
  
  
• Corporate defaults and bankruptcies finally begin to rise as over-levered companies find that raw material costs remain stubbornly high (squeezing profit margins), demand continues to soften and that bankers have learned to say "no."
  
  
• Continued drought in the U.S. Southeast and Southwest wrecks more economic harm than Katrina, and drives home the point that global warming's impact comes more from changes in precipitation than in temperatures. Atlanta becomes the poster child for the economic risks of water stress. As water tables fall, H2O rises as an investment theme.
  
  
• Against the backdrop of drought and weather extremes, the political will to address climate change gathers momentum. For the first time, global warming becomes a major issue in the general election. Wall Street discovers that there is big money to be made in carbon markets, but that it's being made in London.
  
  
• Total oil production again fails to meaningfully exceed peaks established in late 2005 and mid 2006. Prices rise and stay above $100 a barrel despite a global slowdown. Emergent bubbles develop in companies specializing in energy conservation/efficiency and alternative energy. Event-driven, regional supply shortages scare the pants off politicians and consumers alike.
  
  
• Faced with shrinking credit and falling asset prices, officials stop talking about inflation, and the dreaded D word resurfaces.
  
  
• As the de-leveraging of the economy continues, the savings rate rises further, cutting corporate profits. With financial earnings under pressure, equity prices either have to fall or P/E ratios rise. You make the call!

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