Economy: Is the Stock Market Wildly Overoptimistic? Stocks appear to be flying too high in light of the enormous number of risks that the U.S. economy faces over the next 12 months. Despite the Dow's losses over the past few trading days, stocks are still close to their highest levels since the recession ended. Blue chips have almost doubled, in fact, from their 2009 lows. Given the extraordinary risks that the U.S. economy faces over the next 12 months, you have to wonder whether stock investors are being overly optimistic. Almost a year ago, I wrote that the biggest stock market surprise could be an unexpected economic rebound. At the time investors were extremely pessimistic. But within a few months, the economy picked up quicker than anyone expected, and share prices rocketed up 20% to today's high levels. I think the reverse situation may be developing now. Investors are unduly optimistic, and the biggest stock market surprise could be a big unexpected sell-off resulting from some sort of economic crisis. No one can foresee the future, of course, and I'm not forecasting that such a drop will definitely happen. But just as moderate improvements in economic growth and employment last winter led to a sizable market advance, a crisis during the coming months could trigger a decline of 20% or more. Maybe nothing will go wrong - which would be good news both for investors and for President Obama's re-election chances. But it certainly seems as though there are a lot of serious risks right now: MORE: Is This Stock Market Rally For Real? Failure of the euro. The recent Greek elections in which the government coalition suffered huge losses could lead to political chaos - and the possibility that Greece will run out of money in as little as six weeks. Interest rates are again rising in Spain, signaling more uncertainty there. And the crucial economic axis between Germany and France has weakened because the new French President dislikes austerity policies while the German government suffered a bad defeat on Sunday in local elections. The odds of some sort of euro zone crisis just keep rising. Global recession. Even if the euro survives, the policies required to save it have caused a recession. Over the past year, economists have been steadily lowering their growth forecasts for the 17 countries that make up the euro zone and now expect an average GDP decline for the area of 0.3% this year. Some forecasters see a growing likelihood of recession spreading to the U.S. State and pension-fund crises. Governor Jerry Brown recently announced that California faces a $16 billion deficit, which will require higher taxes and additional budget cuts. In addition, the first U.S. public pension fund has filed for bankruptcy in the Northern Marianas Islands, foreshadowing more widespread deterioration of state and local finances. Big losses at major banks. European banks that own lots of government bonds are vulnerable if one of the euro zone countries defaults. And no one knows whether those banks have been totally honest about the extent of their exposure. But the potential for unexpected losses seems to extend much further. Most recently, J.P. Morgan Chase disclosed a $2 billion trading loss, suggesting that U.S. banks still don't have adequate risk-management policies. Rejection of the health-insurance mandate. The Supreme Court is expected to rule on the constitutionality of the Obama health-care plan by the end of June. Rejection of any part of the plan - especially the mandate for Americans to buy health insurance - would have immediate economic consequences. The most direct could be the disruption of Medicare. But broader impact on the health-care system or even the entire economy is possible as well. The so-called fiscal cliff. Under current law, the Bush tax cuts will expire at the end of the year, and automatic cuts in both defense and social spending are scheduled to begin. It's hard to believe that today's polarized Congress will be able to revise these policies smoothly. And if they go into effect without modification, they would hurt stock prices directly by raising taxes on dividends. Equally important, they would have the opposite effect of the recent stimulus plan and create a massive drag on the overall economy. MORE: Stock Market Deja Vu: Why It Feels Like 2011 All Over Again International shocks. Any number of international trouble spots could flare up with significant economic consequences. The top two risks, according to the recent Oxford Analytica Conference, are conflict in Iran or a crash in China. Specifically, a decision by Israel to attack Iran's nuclear facilities could produce a spike in the price of oil. And the slowing Chinese economy could trigger a massive real-estate bust in that country and the collapse of banks holding shaky debt. Why are U.S. markets seemingly ignoring these dangers? Some of it may be a belief that America is partially immune to the world's worst problems. But there's a technical reason, as well. In the short run, markets are driven by flows of money rather than expectations about the long-term health of the economy. Both the stimulus package and the Federal Reserve's quantitative easing injected money into the U.S. financial system, buoying up the prices of stocks and bonds. And right now, hot money is fleeing the most troubled Southern European countries in search of safer havens. We can see that directly in the fact that interest rates are abnormally low in Germany and the U.K., as well as in the U.S. Once a crisis occurs, however, it quickly overwhelms the effect of short-term money flows. There are always significant risks in the world, of course. But the ones on today's list don't seem far-fetched at all. In fact, some analysts would argue that the failure of the euro or the prospect of political gridlock later this year over health-care or tax policy are more likely than not. There's no way to prepare for such eventualities, other than to make sure that you don't get caught totally off balance. I believe that stocks are still good values from a long-term perspective, but my own portfolio is focused on blue-chips with above-average dividend yields, and I've raised my cash reserves to more than 15%. The same sort of defensive posture makes sense more generally as well. It's the possibilities that people are ignoring that have the biggest impact if they do actually occur. And right now, most of those appear to be on the downside.