Shaping a Portfolio for 2011 (lll): what could go wrong/right

what could go wrong?

My base case for the S&P 500 for 2011 is that stocks will go up by 10%.  Personally, I think tb.he year could shape up to be better than that, just as 2010 was. Still, there’s no sense in going overboard by making too aggressive a goal for the year.

If I’m more or less correct, the positives will take care of themselves.  It will be (and always is) much more important to try to think out what could go wrong, how to see the bad news coming and how to defend your portfolio against it.

the obvious

The obvious thing that could go wrong is that we’re at or close to the top of the cycle and that we should be becoming defensive now instead of remaining aggressive.

the rest

Putting that aside, I see a number of main worries:

1.  EU problems with the banks in peripheral countries might spiral out of control—and have negative repercussions for the rest of the world. My guess is that Europe muddles through. But in the final analysis this is a political issue, the kind I find it extremely hard to handicap.

My stance for some time has been to avoid companies with substantial revenue exposure to Europe and to look for European companies with big foreign—US or emerging market—exposure. The revenues and profits of such companies will be relatively secure, and stock market money flow will gravitate to these “safer” names, particularly if worries are accompanied by weakness in the euro.
2.  At some point, the US will remove the emergency stimulus now being given to the economy by super-low interest rates. If there’s a surprise about this process, it may be that action will come sooner than expected (my sense is that the consensus thinks rate rises will begin next winter, at the earliest).

Typically stocks are flat to up during this process. I expect the same will happen this time. But that could be wrong. I’d be more worried if stocks were trading at 25x forward earnings instead of 12x+.

3   The US has accumulated a large amount of government debt. The country’s creditors today are not as charitably-minded as those during the decades immediately following WWII. The consensus view is that he US has considerable time to repair its finances—and even increase its borrowing– without tiiggering a debt or currency crisis. That might prove too optimistic.  Discord in Washington, or some overt sign that politicians are looking to inflation as a way of wriggling out from repaying its obligations, might spark a change of heart.

4.  money flows to emerging markets. It’s important at least at some times, and this is one of them, to distinguish between emerging markets and emerging economies. The practical difference? Citizens in emerging economies usually have very low incomes. They typically have little in the way of savings. Their companies usually don’t offer pensions. Most investors in developed economies/markets realize this much. But from a market perspective, this means there are few, if any, local institutions and virtually no individuals to act as buyers if foreign investors get scared and decide to sell.  Sharp declines in emerging markets could have ripple effects on the rest of the world’s equities.

What could go right

1.  Economic recovery in the US could be stronger than anticipated.

2.  The EU debt crisis might be closer to resolution, or more fully discounted, in today’s stock prices than I think.

3.  Individual investor flows might begin to shift away from bonds and return to stocks, both US and foreign.

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