Where to Invest in 2011

To understand the investing outlook for 2011, it helps to review the year just past. Despite emerging from a long and brutal recession, the economy could muster only an anemic expansion. The most notable manifestation of the tepid recovery was a high unemployment rate that scarcely budged over the course of the year. And yet, over the past year (through November 5), the U.S. stock market managed to post an impressive 17.3% return.

SEE OUR SLIDE SHOW: 11 STOCKS FOR 2011

We think the same pattern -- a stagnant economy but decent stock performance -- may repeat in 2011. The economy should grow by little more than 2.5%, and the jobless rate could even tick up to 10%. But stocks could still return 7% to 10% over the next year, in line with corporate earnings growth and the market's current dividend yield of 1.9%. The Dow Jones industrial average should finish 2011 above 12,000.

(See Risks to Watch below, and What to Buy Now after the jump.)

A number of factors explain the apparent disconnect between the muddle-through economy and the perky stock market. Interest rates are already at rock-bottom levels, and the Federal Reserve Board says it plans to buy $600 billion in Treasuries by the middle of 2011 to keep rates low. The balance sheets of U.S. companies, unlike those of our government and households, are in excellent shape. Profits should continue to rise moderately in 2011 and match or exceed the record level, set in 2006. With Standard & Poor's 500-stock index selling at 13 times projected 2011 earnings, stocks do not appear to be excessively valued, especially relative to bonds and cash.

And let's not forget that the canvas on which S&P 500 companies paint differs from that of the domestic economy. These firms earn 40% of profits abroad, where growth is higher than at home. David Bianco, chief stock strategist of Bank of America Merrill Lynch, calculates that profit margins of U.S. companies are far higher overseas than at home. Bianco says that four sectors in the S&P index -- energy, materials, technology and industrials -- are already generating more than half of their profits abroad. In 2010, profit increases at global companies such as Boeing (symbol BA), Caterpillar (CAT) and Coca-Cola (KO) were powered by buoyant growth in developing countries -- economies that Merrill Lynch projects will generate no less than 75% of the world's economic growth in 2011.

One thing that will change in 2011 is control of Congress, which will be split between a Republican House and a Democratic Senate. This will quite likely produce political gridlock in the nation's capital. Although some observers think that gridlock will be good for stocks because Congress won't be able to enact laws that could harm business, it could be a negative if lawmakers are unable to address a financial emergency.

Risks to Watch

We'd be remiss if we didn't outline some of the risks and lingering structural weaknesses in the economy. Recognizing risks as they come to the fore may help you make mid-course corrections in 2011 and beyond.

Volatility should remain high in 2011 because of contradictory signals from an economy that is expanding in fits and starts. Even Federal Reserve chairman Ben Bernanke frets about an "unusually uncertain" environment. He and most Fed governors think inflation is too low and clearly seek to engineer higher price increases through ultra-loose monetary policy. Because the Fed's gambit is untested, there is a risk that the inflation genie will escape the bottle. "The issue in 2011 is inflation expectations, not where inflation ends up," says Dean Junkans, chief investment officer for Wells Fargo Private Bank. "We're trying to inflate our way to growth."

Government monetary and budget policies are helping to drive the dollar lower, which aids U.S. corporate profits. The trouble is that many other governments are also cheapening their currencies to juice exports and job growth. There is a chance this race to the currency bottom, which is a form of protectionism, could degenerate into a trade war.

After years of delivering stunning gains, bonds may be a less-comfortable resting place for your money in 2011. During 2009 and 2010, individual investors poured more than $600 billion into bond funds. But a rise in long-term interest rates -- a distinct possibility in 2011 -- could result in losses for many bondholders (see our fixed-income outlook -- The Best Bets for Income in 2011).

Surveying the risks stemming from currency wars, and from rising inflation, interest rates and the sluggish domestic economy, Junkans concludes that investors must embrace global investing. "A lot of U.S. investors need to make a paradigm shift in 2011," he says. "Think of yourself as a global investor living in the U.S. rather than as a U.S. investor with some global exposure." In his portfolios, Junkans says, he's increased foreign exposure "permanently" by 50% over the past four years (for more on investing overseas, see The Best Ways to Profit from Emerging Markets.)

Why do we remain dour about the prospects for the U.S. economy in 2011? Our pessimism stems largely from that familiar trinity of linked problems -- housing, banking and busted household balance sheets -- that will dog us for a few more years.

In a normal economic recovery, housing is a key driver of expansion. But home building today remains in a depression. The housing market groans under the weight of a huge backlog of unsold and vacant homes.

Government-encouraged loan-modification programs are not working, and the foreclosure pipeline is clogged. So foreclosures continue to back up, implying that yet more houses will be dumped into a weak market. One of the more pessimistic mortgage analysts, Laurie Goodman, of Amherst Securities, thinks that ultimately 11 million borrowers -- a frightening 20% of the total -- could lose their homes absent a change in government policy.