Can the U.S. stock market overcome an increasingly shaky economy? By Andrew Tanzer, Senior Associate Editor June 3, 2011 Editor's Note: This story has been updated by Senior Editor Anne Kates Smith since its original publication in the July issue of Kiplinger's Personal Finance magazine. If you don't think market forecasting is vexing, try this exercise. Imagine you possessed a crystal ball on January 1, 2011. You foresaw the natural disasters and nuclear accident in Japan, the world's third-largest economy. You predicted political and social turmoil across the Arab world, the war between NATO and Libya, and the spike in oil prices. You anticipated that Standard & Poor's would downgrade its outlook on U.S. government debt to "negative" and intuited that Europe's national debt problems would worsen. Knowing all that, would you have predicted that U.S. stocks would have returned 5.3% over the next six months? The question is whether stocks, which teetered in May and began June with a dramatic downswing, can hold their own amid an increasingly shaky economy. Unemployment remains stubbornly high, wages are stagnant, and inflation in food and energy prices is a painful tax on consumers. Even manufacturing, a source of strength, hiccupped in May. Housing, normally a key ingredient of an economic recovery, is still a disaster area. One-fourth of mortgages are underwater, and 40% of home sales are distressed properties, which is helping to depress prices. JPMorgan calculates that homeowner equity, a pillar of middle-class net worth, has plunged by about 55%, to $6.3 trillion, over the past five years. If the stock market is to regain its footing, it will be on the strength of corporations' remarkable earnings. From Apple to Intel, Boeing to United Technologies, corporations are gushing bumper profits. Companies in Standard & Poor's 500-stock index are likely to generate record earnings in 2011. From the stock market's nadir in March 2009, company profits as well as stock prices have roughly doubled. Advertisement The best gains are behind us, but U.S. stocks could add another 5% by the end of this year. That implies that the Dow Jones industrial average will hit 12,800 and the S&P 500 will near 1400, or about 14 times this year's projected earnings (the Dow closed at 12,151 and the S&P at 1300 on June 3). Rising dividends and strong merger activity should help support stocks. So will the Federal Reserve Board's easy-money policies, which are keeping interest rates at extraordinarily low levels and forcing investors to take risks in search of decent returns. So why are corporate earnings so buoyant? One explanation is the composition of the S&P index. Bank of America Merrill Lynch strategist David Bianco says that 45% of earnings are generated by four sectors -- energy, materials, technology and industrials -- that are closely tied to global economic growth. These days, that growth comes largely from emerging markets, which may account for two-thirds of global expansion this year. Shifting Landscape The economic recovery is now maturing into expansion, which implies some shifts in the market. Year-over-year earnings gains will shrink, and investors will grow more discriminating in selecting stocks. Early in the cycle, small and highly leveraged firms perform particularly well. Later in the cycle, says Putnam strategist Jeff Knight, investors rotate toward larger companies with better balance sheets and more-durable growth. As you invest, don't throw caution to the wind. Plenty of risks remain. One challenge will be the end of the Fed's program of buying Treasury bonds to hold down long-term interest rates. No one knows for sure how the Treasury market will react to the winding down of the so-called QE2 stimulus program, but the action will clearly represent a de facto tightening of monetary policy. "The market will have to attract real buyers of Treasuries and find out what real demand is," says Brian McMahon, chief investment officer at Thornburg Investment Management. If an insufficient number of those real buyers show up, bond yields could rise, threatening to derail the fragile economic recovery. Advertisement Low interest rates in the U.S. are raising the risks of higher inflation and a crumbling dollar. Our interest-rate policies are out of whack with those of the rest of the world. For instance, the European Central Bank, worried about inflationary pressures, has been raising short-term rates, while our Fed, under chairman Ben Bernanke, has kept them at rock-bottom levels. That has undermined the value of the dollar, and there's always the chance that an orderly decline can turn into a rout. Our low interest rates are surely playing a role in soaring gold prices, too. The metal has recently retreated from a record high in May, but bullish underpinnings remain. Foreigners, who buy a lot of our Treasuries, are snatching up the precious metal instead because they are becoming increasingly concerned that our official policy is to stimulate inflation, debase the dollar and repay our colossal foreign borrowings with cheaper dollars. The Fed's money-inflation policy is also contributing to rising food and energy prices (most commodities are priced in dollars). Surging fuel prices have already wiped out the benefits to most households of this year's two-percentage-point cut in the Social Security payroll tax. (See What the 2011 Tax Cut Is Worth to You.) We may be nearing the point at which higher oil prices choke off the economic recovery. Investing overseas comes with its own set of risks. In Europe, the sovereign debt crisis is far from resolved. In early June, details of the second Greek bailout in a year were finalized, and worries remained about potential defaults in Ireland and Portugal, too. A restructuring of debt, in which banks in France, Germany and elsewhere take a buzz cut on their loans, may be inevitable. Advertisement Developing nations are growing robustly, but inflationary pressures are rising in several places. Especially vulnerable are countries with currencies tied to the shriveling dollar and with a high ratio of food costs in their consumer price baskets -- think North Africa and the Middle East. Central banks in India and China have been raising interest rates to fight inflation, but their actions may come too late. Yet sharp-eyed investors are spotting good value around the globe. Sarah Ketterer, manager of Causeway International Value Fund, says quality stocks are on sale. "You don't need to go into the junkyard" to find attractive buys, she says. For instance, she likes Honda Motor (symbol HMC), whose shares have been beaten down over concerns about temporary parts shortages after Japan's earthquake and tsunami. Honda, she notes, is highly profitable, financially strong and growing well in areas such as the Southeast Asian and Latin American motorbike markets. Ketterer is also keen on Swiss drug giants Novartis (NVS) and Roche (RHHBY), both excellent businesses with stocks yielding about 3% and 4%, respectively. Brian McMahon, who co-manages Thornburg Investment Income Builder, is also gravitating to solid foreign firms paying juicy dividends. For instance, he holds big European oil firms, such as Royal Dutch Shell (RDS) and Total (TOT), as well as telecom outfits, such as Vodafone (VOD), which owns half of Verizon Wireless, and Australia's Telstra (TLSYY), whose stock yields a hefty 8.5%. If you want a pro to pick your foreign stocks, consider Harbor International (HIINX) or T. Rowe Price Emerging Markets Stock (PRMSX). See our 2011 midyear investing outlook for fixed-income investors: What Now for Bonds?