The markets and the global financial community are enjoying a lot of liquidity. Low interest rates continue, raising equity or debt capital is easy and asset markets are buoyant with at least as many buyers as sellers.

The story of 2006 was a story of buying: M&A activity surged, only to be outdone by private equity buyers. Stock prices rose too, as interest rates softened and risk spreads narrowed. The only markets that fell were those that everyone agreed were "too high": U.S. home prices and the U.S. dollar. Further, in both cases, the experience so far brings to mind Mark Twain's comment, "reports of my death have been exaggerated." Supporting all this strength were a series of pleasant surprises, as most markets and economies outperformed the expectations and forecasts offered a year ago.

Defining and measuring liquidity may not be simple, but its effects are important. At the level of a stock trade or an index adjustment, liquidity means executing the trade without having the price move much. At this level, liquidity can be gauged by a stock's average daily trading volume, by how much of its market value turns over in a month or a year or by how many days of trading at average rates are needed to complete a specific transaction. In a broader sense, liquidity means being able to raise the cash necessary to complete a transaction in a timely manner. If liquidity is available, the chance that closing a large acquisition or completing a capital investment will be delayed because the financing is not in place is remote. This broader sense of liquidity may be harder to measure since few people track delayed investments or deals lost because financing was not available. Nonetheless, virtually all the news and experience of 2006 argues for plentiful liquidity.

Liquidity does much more than just lubricate the markets and smooth the way for a few M&A deals; liquidity drives down peoples' risk aversion so that the money flows. Liquidity creates an increased willingness to accept smaller risk premiums or to pay higher prices for almost any asset. If the liquidity disappears, risks will look larger and prices will become lower.

Reading through the crop of forecasts for 2006, one finds a lot of optimistic, rosy outlooks. Are these glowing predictions justified by economic and market conditions, or is this optimism driven by liquidity and the hopes that momentum will sustain the markets?

The divergence between financial market and economic prognostications on one side and much of the recent political commentary on the other makes one wonder. Further, some of the current economic trends are unsustainable, and it is just a matter of time until things change. Finally, in some spots, the momentum may even be headed the wrong way.

One of the peculiar things about liquidity-driven markets is that, during these markets, most people feel rich, and it is difficult to convince them that anything might go wrong. In the comments below, I focus mostly on the negative—not because I can't see anything positive, but instead as a means of rebalancing the outlook.

Although politics may be outside the range of things financial market participants usually consider when evaluating investments, they deserve some mention because they are generating a great deal of angst in other areas of debate. Short-term issues include the Iraq war and other Middle East turmoil that could push oil prices sharply higher, and concerns over North Korea and its nuclear arsenal. A longer-term issue that should concern the markets is the future of globalization. Globalization has opened markets, reduced costs, boosted corporate profits and helped raise incomes and living standards across the world. But it has also generated a backlash that may be gaining strength and could threaten the gains of the last five to 10 years.

If any of these issues spawn really nasty front-page news, they could cause momentary paralysis in the markets, reminding people that plentiful liquidity can dry up quickly. Such events would also mean much greater aversion to risk.

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