A Tale of Two Economies

While election years have historically been positive ones for the stock market, we're not exactly living in normal times. The domestic economy is suffering from an ongoing debt hangover while nations around the globe are struggling with their own fiscal problems. We're walking a fine economic line right now, and it wouldn't take much to push us over to either side. Here's a breakdown of two ways the rest of the year could play out and what investors can expect as a result.

Scenario No. 1: A growth surprise
Some important economic data has surprised to the upside in recent weeks -- especially on the jobs front, which has been a thorn in this recovery's side for years now. Initial jobless claims have been falling steadily lately, and the four-week moving average of claims is now close to a four-year low. Job creation has also been picking up, with January ushering in the biggest gain in new jobs in nine months. Some folks are starting to wonder if our fragile economy has finally turned the corner and if we could be in for a higher rate of economic growth.

Given what's been going on in the market year to date, investors are seeing this scenario as increasingly likely. Small-cap stocks have raced ahead of larger names as investors suddenly rediscover their appetite for risk. If job creation continues to stay strong, with the economy creating in excess of 200,000 jobs a month, odds are good that the market will take a "risk on" position for much of the rest of the year. In such an environment, we're likely to see more speculative and lower-quality investments get a boost.

To profit in such an environment, investors would want to crank up the risk in their own portfolio. With higher-risk securities back in favor, small-cap stocks should continue to outperform. On the fixed income side, high-yield bonds should also do well under such a scenario. In fact, the SPDR Barclays Capital High-Yield Bond ETF (NYS: JNK) is up 2.7% already this year and could see greater gains if risk remains in favor. And if you're really willing to go out on a limb to capture some gains in this potential scenario, you might want to consider investing in one of the most beaten-up sectors around -- financials -- which should gain ground if growth kicks into high gear.

Scenario No. 2: Global turmoil
Of course, we can't forget about the looming debt crisis brewing over in Europe. It's still likely that Greece will end up defaulting on its debt obligations in some manner, and the repercussions of such an event would be felt all the way across the Atlantic. The U.S. is struggling with its own mounting debt load and while little will likely be accomplished before the election this fall, we will have to face some difficult facts in dealing with our financial situation.

While the market doesn't seem to be pricing in a doomsday scenario right now, we know from recent history that things can change on a dime. Back in early 2011, the economic outlook appeared to be brightening as well, but the tsunami in Japan, debt ceiling standoff, and U.S. credit rating downgrade all helped bring us perilously close to a double-dip recession. So it's not out of the realm of possibility for 2012 to end up two steps behind where we started the year.

In the event that the situation in the eurozone turns nasty and global growth takes another hit, investors will obviously benefit from a more defensive posture. Bonds, especially U.S. Treasuries, will likely have another winning year. Under such a scenario, gold will probably reach new highs, and we'll see even more assets flow into funds like SPDR Gold Trust ETF (NYS: GLD) as investors seek safety once again. While equities would take a hit, chances are U.S. stocks would hold up better than many overseas markets, so investors might do well to go light on euro-centric stocks and funds like iShares MSCI EMUETF (NYS: EZU) .

You make the call
So which scenario is more likely for 2012? My best guess is that real life will play out somewhere between those two extremes, but likely a bit closer to the first scenario than the second. Economic growth should be stronger this year than last, but it will probably still come in below trend. But while small-cap names have outperformed in the opening weeks of the year, I still think large-cap stocks will have the upper hand when the final tally is counted at year's end. By now, much of this year's upside potential for smaller companies has probably already been priced into the market.

Given that large-cap companies typically outperform after the first few years and the initial stages of an economic recovery, investors should make sure they're not ignoring financially stable large-cap names in favor of flashier small-caps. Make sure you've got your small-cap bases covered, but consider directing any new money to high-quality domestic blue chip stocks, or ETFs Vanguard Dividend Appreciation ETF (NYS: VIG) or SPDR S&P 500 ETF (NYS: SPY) . Don't cut back on your foreign holdings, but be prepared for more volatility overseas as officials attempt to resolve the ongoing fiscal crisis.

If you've jumped on the gold bandwagon, make sure you've limited your exposure to a small portion of your portfolio -- at current prices there's a lot of risk in the gold trade. And unless you're already retired or close to it, make sure the majority of your portfolio is in equities, as bonds simply don't have the room to continue producing at the level they have in recent years.

Ultimately, even if a stronger growth trend takes hold in our economy, don't expect the current taste for risk in the market to last forever. That means being prepared for a short-term pullback but also positioning your portfolio to take advantage of the longer-term trends likely to dominate 2012 and beyond.

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At the time thisarticle was published Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. The Motley Fool has sold shares of SPDR S&P 500 short. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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