(Reuters) - If you want to be optimistic about investing this year - and there are plenty of reasons to be - you need to understand the tale of two economies.
One narrative is the recovering U.S. economy: Robust corporate profits, increased manufacturing, slightly more hiring and continued global demand. The other story tells of a hobbled euro zone, a possible slowdown in China and the prolonged misery of the U.S. housing market.
Which tale do you choose to believe? I'm loath to forecast which scenario will dominate because both will play out in varying degrees. The euro zone downgrades last week(link.reuters.com/pyw95s) are certainly going to reverberate in the markets, so if you're over-exposed to European debt and stocks, pare back. In any case, you should be upgrading your portfolio to grab growth and income while reducing risk.
Keep in mind that my observations are not predictions and based on my Totally Oscillating Algorithmic Sentiment Trends (TOAST) strategy. That is, things change quickly and you need to figure out how much money you can afford to lose in an ever-volatile market. Here are some trends worth noting:
Housing will still be hurting, but could be jump-started. While Ingo Winzer's National Economic Outlook (www.localmarketmonitor.com/) is generally optimistic, he doesn't see a U.S. housing rebound. "The evidence is now pretty clear that a sustained economic recovery is underway, although housing markets won't feel much benefit until next year," Winzer writes.
He sees rough patches where there's poor local economic health in Atlanta, North New Jersey, Fresno, Indianapolis, Kansas City and Philadelphia. This could change if the White House, the Fed and banks allow widespread refinancings or principal writedowns for underwater homeowners or those in foreclosure. Mortgage rates are still at generational lows.
The Leuthold Group's (www.leutholdfunds.com/) reading of the Dow Theory indicators shows a "new bullish reading on their major trend index," according to the firm's latest newsletter. But don't buy stocks from the leading sectors of last year. In what Leuthold calls the "Bridesmaid" strategy, buy stocks from the second-best performing sector of 2011: Consumer staples.
That makes sense if the U.S. stays in rebound mode. From 1991 through 2011, Leuthold claims their strategy produced a 13.4 percent annualized return, compared to 8.8 percent for holding the S&P 500 Index. Some ETFs to consider include Vanguard Consumer Staples VDC.P and SPDR Consumer Staples Select XLP.P.
If the rebound scenario is valid, you'll want to be in dividend-paying blue chips. Reports Standard & Poor's Marketscope, "within the growth sector, we think stocks categorized as large-cap growth are more likely to benefit from an improving global economy with less volatility than smaller or mid-cap stocks." The SPDR S&P 500 Growth ETF SPYG.P is a good place to start.
Money manager Michael Gayed of Pension Partners, LLC, says he's optimistic "because the initial start to the year is signaling inflation expectations are returning, which is a favorable environment for stocks." While a little inflation helps stocks, keep an eye on the larger inflation picture, which hurts bonds.
If you want to adopt an ambitious global view, then the return of growth will trigger more buying of energy, agricultural commodities and metals. Dennis Gartman, a trader who publishes the Gartman Letter (cloud.thegartmanletter.com/), says the turnaround scenario favors grains, soybeans, cotton and oil. Speaking at the Executive Club of Chicago on January 12, he says he's bearish on the Euro and insisted "the U.S. dollar will remain the world's reserve currency." The Powershares DB Commodity Index Tracking Fund DBC.P gives you broad exposure and provides an inflation hedge.
No yearly outlook, however, would be complete without some wildcard scenarios. There's still a U.S. election coming up, Congress has yet to resolve its debt ceiling/deficit cutting debate and it's unclear how, or if, a European slowdown will impact the U.S. and China. The Iranian government is also threatening to shut down the vital Strait of Hormuz, a major conduit for Middle-East oil.
If you can ignore the headlines - that's my advice - focus on risk-budgeting in your portfolio. Look carefully at your exposure to Europe, U.S. stocks, bonds and commodities. Are you insulated from another meltdown? That way, forecasts won't matter because you won't need to monitor the markets daily. Predictions are not the same thing as preparation.
The author is a Reuters columnist. The opinions expressed are his own.
Editing by Lauren Young and Beth Pinsker Gladstone