As the 2012 trading year starts to unfold, investors may already be forgetting an important lesson learned in 2009, 2010 and 2011: There is no such thing as an extended rally or an extended slump. The market fixates on good news for a few weeks -- even a month or two -- and then takes an opposite tack, concluding that the sky may be falling. The only winning formula in such an environment is to focus on the potential positives when stocks are hated and to anticipate trouble spots when stocks are loved.
I've been thinking about this in recent days as U.S. stocks start to percolate while European economies slip into a clear-cut recession.
The near-term is crucial. The S&P 500 has near-term resistance at around 1,285, and we're back near this level, which was last seen in late October.
This disconnect between rising U.S. stocks and a still-scary crisis unfolding across the Atlantic can't last for long, so investors need to stay very focused on what is happening in Europe. Either Europe will (finally) get its act together, justifying the market's recent optimism, or U.S. stocks will succumb to gravity's pull.
Here's the latest snapshot of the European mess, and how it could affect U.S. stocks in coming weeks and months.
Just this week (Jan. 9), the leaders of France and Germany delivered another stern threat to Greece: "Cut your budget sharply before we disburse any more loans." Trouble is, politicians in Greece have already made a series of belt-tightening moves and it's unclear whether they have the political will to make further cuts. Greek citizens have become more vociferous in their view that any more cuts will lead to even deeper social distress. Still, Greece has already received $165 billion in aid -- and needs more just to keep from entering into an even deeper economic spiral.
"The situation is very strained, maybe more than ever before in the euro area," said France's Prime Minister, Nicholas Sarkozy, in a press conference on Monday, Jan. 9.
Concerns are building that there won't be any tidy resolution to the battle of wills between the strong Northern European countries and their ever-weakening southern neighbors. As a result, the euro hit a 16-month low against the dollar on Monday, dropping 0.2% to $1.27.
Germany's Chancellor, Angela Merkel, and France's Sarkozy are well aware of the risks. And they are unlikely to wait too long with the next round of financial support, as they have no intention of letting the Greek crisis truly spiral out of control.
But that's not what should be worrying investors.
Investors should be attentive Europe's new reality once this crisis is resolved. I still believe Greece will eventually depart from the European Monetary Union, which would actually be a welcome long-term development for the global economy. (Greece is one of 27 members of the European Monetary Union and one of 17 countries that have formally adopted the euro.)
Long before this possible event happens, though, investors need to understand the latest events in Greece, Italy, Spain and Portugal. There's a big difference between a brief, mild recession, and a long and deep recession. A brief economic shrinkage followed by an economic upturn makes it easier to see how these countries might eventually generate the revenue to start paying off massive debt loads. Unfortunately, it's hard to see how these lagging economies can avoid an even deeper economic retrenchment -- one which makes it hard to make a dent in debt burdens. And if that's the case, then continent-wide economic expansion will also grind lower.
This would be bad news for U.S. stocks.
Let's look at where these economies have been in the past five years and where economists predict they will be in 2012. Note that the deepest hits appear to have taken place in 2009, but 2012 will likely bring a fresh slump, according to Ernst & Young.
Don't think the northern European economies can escape the negative effects of shrinking economies to their south. Goldman Sachs predicts the gross domestic product (GDP) in Europe will drop from 1.5% growth in 2011 to an 0.8% shrinkage in 2012.
But the investment firm can envision positive and negative outcomes to the current crisis:
"Embodying the necessary political progress, our base case foresees some stabilization of financial markets in the second half of 2012, as clarity emerges about the roadmap for euro area institutional and governance reform. This should prove sufficient to arrest the contraction of the area-wide economy, if not that of the periphery. But it is all too easy to imagine an alternative outcome: taking the economy to the precipice in order to force political decisions risks miscalculation -- and some countries toppling over the cliff, with potentially catastrophic consequences. We may have come uncomfortably close to such a scenario in the last quarter of 2011," they wrote in a Jan. 6 note to clients.
It's that phrase "potentially catastrophic consequences," which explains my inability to trust any rally we see here in the United States.
To be sure, fourth-quarter results, in aggregate, are likely to meet or exceed analysts' forecasts. Yet the forward view may be uninspiring, as the specter of further European weakness leads many companies to set a low bar in 2012.
Risks to Consider: A cautious stance is essential in the face of a rising U.S. market and a weakening Europe. But stay tuned. If policy makers can drum up a viable solution and these economies get the support they need, then those Ernst & Young forecasts may prove too dire, and it would be time to be positioned for a market rally. Such a tidy resolution appears unlikely, in my view.
This is a moment to harvest gains. The best place to start is with stocks that have surged recently, and are thus likely less expensive relative to peers than they were a few months ago.
Though I like a number of companies on this list, timing is crucial if you are to make money with them. For example, shares of Micron Technology (Nasdaq: MU) are up more than 20% since I recommended it in early December.
Though I suggested shares could move into the low teens, this stock tends to surge ahead and then drops back, so I'd suggest seeing how long the current upward move can last first -- and then quickly book profits once it appears the tide has turned.
This may already be happening with Akamai Technologies (Nasdaq: AKAM). This stock looked quite appealing, even after it spiked from $20 to $24 in early October, and indeed shares posted solid gains in subsequent months. But this stock has been stuck around $32 for roughly two weeks and the sideways chart suggests that the time is at hand for profits. If history is any guide, then a quick-rising stock like this consolidates down to lower levels, setting up the next compelling entry point.
Action to Take --> What does this have to do with Europe? Everything. Many of these recent strong gainers only rallied because concerns about Europe slipped from their peak last summer. Those concerns have not gone away, and we're just one set of scary headlines away from the next market reversal. If you own any of these stocks (or others with exposure to Europe), then take a long, hard look and decide if you want to sell.
D. Sterman does not hold positions in any securities mentioned in this article.
StreetAuthority, LLC does not hold positions in any securities mentioned in this article.
This article originally appeared at www.streetauthority.com.