Predicting America:

As we head to the finish of 2010, the economic situation in the US seems to be on the upswing. There are a number of reasons for investors to be confident about the coming year barring any black swan events that may derail economic recovery (and the imminent collapse of a few more Euro zone economies might tip the scale to the negative side). I prefer to be cautiously optimistic about the US economy in 2011. As an optimistic year end target, I would say the S&P 500 should finish at 1450 in December 2011. As always, there are many factors to consider before establishing a medium to longer term view of the US:

The Good: 

A big reason for the upswing in the US over the last year has been the increase in business investment, which has risen by nearly 20% over the last four quarters. A point that is repeated over and over in discussions about the recovery in the US economy is that it has to be lead by the private sector. Clearly the government is not going to be creating too many jobs any time soon. Unemployment remains to be the Achilles Heel in the recovery process, and this was echoed by the November non farms report, which showed a rise of only 39,000 jobs. This was a sharp decrease from the numbers in October coming in at 172,000. An average over the two months shows a modest increase of 105,000 which is indicative of a sluggish pace of job creation. However, at the same time, the ISM manufacturing and non manufacturing employment estimates have seen their four week moving average fall to the lowest levels since 2008, which bodes well for a continued upswing in 2011.

Consumer confidence has also been on the upswing, as people look to be spending money again. The good part is that the majority are no longer spending debt, and sticking to spending based on their incomes. The ratio of consumer credit to household expenditures are on decade long lows. Boosted by the Christmas cheer, retail sales have also picked up over the last few months, especially ex auto sales numbers which pointed to a 1.2% gain in November.   

The Bad: 

Off late, there has been a lot of talk about the increasing yields on US government bonds. For investors in the US, the bond markets have been a pretty dull place to be for some time now, as the yields are not anything to write home about. However, there has been a slight surge in yields over the past couple of months, lead by the poor fiscal situation which is likely to be further exacerbated by the budget agreement between Obama and the Republicans. 

The $858 billion dollar bill to extend the Bush era tax cuts which was recently passed by Congress is going to take a toll on the fiscal deficit which already stands at nearly a whopping $14 trillion. With debt levels inching their way to 100% of GDP, it is certainly not a gamble to be predicting a loss in investor confidence in the US fiscal situation in the long term if growth does not pick up as projected by the bill and if there are no sustainability measures put in place over the next few years to get the debt trajectory back on track. The fiscal responsibility could come in the form of cuts in defense spending, caps on discretionary spending, raising the retirement age, and reducing tax breaks on certain sections of society. However in the nearer term the cause for concern is not at very high levels as the increase in yields could be an indication of return to a normal economic environment more than anything else (after all a lot of intervention was required to keep yields low so far). 

Rise in yields across the board

The Ugly:

There are a number of local governments in the US which are knee deep in debt. The rise in yields of municipal bonds or "munis" as they are fondly referred to by investors, is a major cause for concern. A significant amount of attention was paid to municipal bond expert Meridith Whitney, who on CBS 60 Minutes voiced her concern stating that she sees about 50 to 100 major defaults amounting to hundreds of billions of dollars of defaults. While the way the real situation may pan out can be very different from her predictions, as municipal bonds have been historically safer than corporate bonds and there is a recoverability rate of about 66% on defaulted munis; even a fraction of her predicitons coming true would add to the US fiscal voes in a significant way.

An added cause for concern is the overbought and overvalued situation in the equity markets. John Hussman has listed out the following factors which make me weary:

1) S&P 500 more than 8% above its 52 week (exponential) average 
2) S&P 500 more than 50% above its 4-year low 
3) Shiller P/E greater than 18 
4) 10-year Treasury yield higher than 6 months earlier 
5) Advisory bullishness > 47%, with bearishness < 27%

These above conditions are indicative of the US economy before many major market meltdowns and corrections over the last dew decades. Market timing is also a major issue, with some traders getting bullish after a rally and bearish after a market fall. A smart investor would hedge his/her bets with some care with regard to predictions about the US economy and equities in particular in the coming year.