2011 Market Outlook, Why I'm Bullish on Stocks

At risk of offending any vegetarian readers, few meals are more delectable than rare roast beef served with root vegetables and a Yorkshire pudding cooked in beef drippings. During my time in London, I enjoyed making my regular Sunday constitutional to the local pub for a delicious roast. I haven’t abandoned this tradition; every time I return to the UK I make time to enjoy this gastronomic delight.

Unfortunately, I’ve never been able to re-create a proper Yorkshire pudding in my own kitchen. What should have come out as a light pastry would always emerge from the oven as a doughy mess.

But this Christmas, the Yorkshire pudding that accompanied my standing rib roast came out perfectly. Perhaps it was the new flour I purchased or the organic eggs from my local farmers market, but I’ve produced enough subpar Yorkshire puddings to know that my success stemmed purely from luck.

I don’t know how many investors tried their hand at a roast over the holidays, but many likely disengaged from the markets for a few days to attend to seasonal tasks. For those of us who closely follow the financial markets, disconnecting--even for a few days--involves a certain degree of separation anxiety.

But forgetting about the day-to-day market action is the best move you can make this time of year. Most of the Big Money is on holiday, many foreign markets were closed for at least part of the week, and wintry weather is wreaking havoc on New York and London, reducing trading volume in the final week of 2010. Investors shouldn’t read too much into the market’s moves over the next few days.

Now is the time to reflect on 2010 and develop a coherent strategy for 2011. That’s exactly what I did in the most recent issue of Personal Finance.

Bearish commentators had it wrong in 2010: The S&P 500 is poised to end the year with a 13 percent gain and remains within spitting distance of its 52-week high, in line with my prediction of a 10 to 15 percent rally.

Although I share some of the bears’ concerns about the long-term economic outlook for the developed world, the stock market’s recent rally is grounded in solid fundamentals. As I’ve predicted all year in Personal Finance Weekly, the US economy won’t suffer a double-dip recession. The expansion that started in mid-2009 has been decidedly subpar, but slow growth is better than no growth.

And US economic growth appears to be accelerating. The November reading of the Conference Board’s US Leading Economic Index (LEI) was up 1.1 percent from October--a bullish indication--while the extension of the George W. Bush-era tax cuts is another positive development.

US gross domestic product should grow roughly 3 percent in 2011. Hiring will also pick up steam next year, with the unemployment rate decreasing slightly in the final six months. These improvements should push stocks 15 to 20 percent higher on the year.

That’s not to suggest that stocks are in for a smooth ride. The fiscal health of a handful of EU countries remains a concern. Uncertainty about Greece’s solvency and other peripheral EU economies sparked a correction in the S&P 500, which gave up 17 percent between April and June 2010. Similar concerns about Ireland prompted the S&P 500 to pull back 5 percent in November.

In 2011 attention will shift to Portugal and Spain, two nations that could require a bailout. Further turmoil in EU sovereign debt markets could send global stock markets temporarily lower.

But the market has a better understanding of Europe’s credit woes, while overblown concerns about the dissolution of the EU and a second global credit crunch appear to have faded.

The eurozone has implemented a system for bailing out countries in exchange for agreements to implement fiscal austerity measures. And countries throughout the EU have overcome resistance from a vocal minority and implemented austerity measures that will put them on a more sustainable path over the long haul. Even more impressive, EU austerity has focused more on cutting governmental spending than it has on raising taxes--historically, a key to lowering deficits without jeopardizing economic growth.

What about the latest bearish argument that the recent increase in interest rates will sidetrack the US economy? This fear puts the proverbial cart before the horse. Rates are rising because the market is discounting stronger US economic growth and future inflationary pressures. If the rally in rates reflected near-term concerns about US fiscal policy, financial stocks would lag the broader market instead of leading it higher.

Not all of my predictions for 2010 have come to pass; my biggest error was underestimating the resilience of the US consumer and retailers. I expected US consumers to continue to deleverage and rein in spending, a trend that should have weighed on consumer discretionary names.

Although households continue to pay down debt, this process is far enough along that consumers felt comfortable shelling out this holiday season. Meanwhile, I was dead wrong about consumer discretionary stocks; this sector led the market in 2010. Fortunately, a strong performance from our favored sectors in Personal Finance made up for this oversight.

Don’t let the bears coax you into hibernation in 2010; the stage is set for the market to rally in 2011. Investors should focus on our Fab Four sectors: energy, industrials, basic materials and technology. The latest issue of Personal Finance runs down our favorite picks within these groups.

Not a Personal Finance subscriber? Sign up for a risk-free trial of the newsletter to gain access to my top stocks for 2011. Click here for more details.

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Most investors have a natural aversion to buying a stock after a significant rally. After all, no one wants to overpay. Many spend weeks watching a stock rally, waiting patiently for an opportunity to jump aboard at a more favorable price.

Timing market corrections accurately is an extraordinary challenge. Oftentimes, the market’s upward momentum means that anticipated pullbacks occur from much higher levels.

In recent weeks some have speculated that the S&P 500 will pull back in early 2010, noting that sentiment has become overly bullish and that the market is due for a rest after the recent rally. A graph like the one below typically accompanies such articles.

his graph tracks the percentage of respondents to the AAII Investor Sentiment Survey who expect the market to head higher over the next six months. As you can see, the recent spike in bullish responses is the highest reading in some time. Conventional wisdom suggests that high levels of bullishness signal a market that’s due for a pullback.

This argument doesn’t hold water. Bullish sentiment reached similar levels in June 2003 as well as in November, April and January 2004. In every case, the market traded higher three months later, and the average gain was an impressive 8.6 percent. Apparently, bullish sentiment isn’t so bearish after all.

Fear and general bearishness usually accompany meaningful pullbacks, paralyzing many of the investors who decided to stand aside until such a correction occurred.

Subscribers often ask me whether it’s better to buy a hot stock and risk missing a near-term pullback or wait for a correction that may never come.

Unfortunately, there’s no easy solution to this conundrum, though breaking up your investment into multiple purchase can help. For example, if you wish to buy $15,000 worth of a particular stock, consider making the purchase in three increments of $5,000 over several weeks or months.

If you immediately deploy a third of your money, you’ll have some exposure if the stock keeps rallying but won’t get burned too badly if there is a near-term correction. Meanwhile, if the stock pulls back, you’ll also have some dry powder to take advantage of lower prices.

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