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The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By Doug Roberts, Chief Investment Strategist for Channel Capital Research



) -- Santa Claus arrived late last year with the rally continuing. The S&P 500 finished with a positive return. This continued with a strong return for the start of 2012. Economic numbers are improving albeit very slowly.

What is the source of this economic improvement? Can it last? In 2012, will the rally continue or will a downward spiral start again; or are we perhaps in a broad, extended trading range? This is the subject of this month's commentary.

A Quick Summary of the Economic Good News

Economic numbers have improved during the last month. The ISM indexes for both manufacturing and services have increased indicating an economic recovery. Manufacturing seems to be coming back to the United States. The car industry also appears to be experiencing growth. This phenomenon is something that we have not experienced over the last 30 years. Retail sales were also quite strong.

The biggest positive news lies in the employment numbers. Nonfarm payrolls increased by 200,000, exceeding expectations of 150,000. The unemployment rate was also reduced to 8.5%, which was unanticipated. Average workweek and hourly earnings both increased.

This has led some commentators to say that we are finally at the start of the long-anticipated economic recovery. They believe that this recovery may be self-sustaining and bodes well for investment returns in 2012.

A Closer Examination of the News

In order to get a true picture of the implications of this news, we need to probe beneath the surface numbers to get a better understanding what really is happening. This is critical to determine if the current economic strength will continue.

If we look at the ISM reports, we see that the increases were quite modest. In both cases, the readings were only a few points above 50, which is the dividing line between expansion and contraction. Thus far, this does not appear to be the beginning of the "V-shaped recovery" that everyone has been forecasting.

Strength was also concentrated in ISM Manufacturing, which also exceeded expectations. ISM Services actually lagged expectations. Since the United States is primarily a service-oriented economy, ISM Services will need to show strength for the economic improvement to last.

The positive nonfarm payrolls report was also supported by a strong ADP report which massively exceeded expectations. The initial claims report was also better than expected.

However, 25% of the increase in nonfarm payrolls was due to increased employment in transportation and warehousing. Almost all of the gain was because of an increase in couriers and messengers. These jobs may be seasonal, raising questions as to whether this will be reversed in the near future. The previously reported nonfarm payrolls number for the previous month was also revised lower.

Retails sales were strong, but retailer profits suffered based upon initial reports. It appears the consumer bought because there were bargains. We will soon see if this was simply a form of borrowing from future consumer purchases.

Bonus Depreciation

Many have forgotten that we previously enacted a government stimulus program whose effects continue to be felt today. The increase in manufacturing recently felt may be due to this.

The "Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010" allowed for full 100% depreciation of new purchases made in 2011. It decreases to 50% depreciation in 2012. This was a tremendous incentive for people to place orders last year. Because of uncertainty and procrastination, many people waited until the last moment to place orders.

This also includes large autos used strictly for business purposes. This could account for the robust sales recently experienced by auto companies, especially in SUVs.

Even though the bonus depreciation benefit has greatly been reduced in 2012, this may result in continued strength for manufacturing this year. Again, the question becomes whether these are purchases that are borrowed from future years.

Government Gridlock and Uncertainty

Although Congress and the President agreed to a temporary fix regarding tax benefits and budget negotiations last year, this only lasts until February. At that point, the arguments will begin again.

With the current gridlock and acrimony in Washington, D.C., there is substantial uncertainty regarding the final outcome. No one is sure that Congress will extend the key deductions.

If this fiscal stimulus is reduced, this could have a substantial effect on the economy. The nascent recovery that we are seeing could quickly fizzle.

Lender and Spender of Last Resort

Recent economic reports definitely indicate a recovery, but as I have mentioned, the improvement has only been marginal at best relative to the fiscal and monetary stimulus and the amount of time that it has taken for this to occur. Although these numbers are still in positive territory, many are still uncertain about the future and believe that without further government intervention, we could slip back into a recession.

Any improvement in the economy has been quite limited with only a small segment of the population participating, leading to what we described as "two economies." One has seen a rebound, but the other has not really experienced much improvement.

This has really not borne any resemblance to the "V-Shaped" recovery that many were forecasting. It is much closer to the jagged "U-Shaped" economic recovery that we predicted.

I have said previously that this is quite different from earlier recoveries. In most of those earlier cases, government stimulus merely "primed the pump" until the private sector took over. Now, government remains "the lender and spender of last resort."

The European Financial Crisis

Many pundits were saying that the central banks and the governments were powerless to stop the downward spiral due to financial crisis in Europe. Bearish sentiment was rising to elevated levels. Then, just as it appeared the markets were going to crash, coordinated central bank intervention was announced.

The Federal Reserve, the European Central Bank, the Bank of England, the Swiss National Bank, the Bank of Canada and the Bank of Japan announced "coordinated actions to enhance their capacity to provide liquidity to the global financial system... These central banks have agreed to lower the pricing on the existing temporary U.S. dollar liquidity swap arrangements by 50 basis points so that the new rate will be the U.S. dollar overnight index swap (OIS) rate plus 50 basis points." Separately, the Bank of China eased as well.

The question becomes whether the rally will continue. There has been no real solution to the crisis. The only positive news seems to be statements by Germany and France that they will eventually resolve the problem and not abandon the Euro.

Other Significant Threats

The Arab Spring continues to be an Islamic Winter. There is a real possibility of an Islamic government in Egypt and questions about abrogating its current Peace Treaty with Israel. The current military government will not allow this to happen. There is a real possibility of a civil war in Egypt.

Iran is also continuing with its nuclear program despite U.S. opposition. If it continues on schedule, it is possible that it could pass the point of no return within the year. There are rumors that the Israeli government may be planning a strike on Iran to prevent this.

Thus far, these situations appear to be contained. However, the potential for the outbreak of hostility still remains. There could also be serious problems if the budgets required by the super committee failure are instituted. Many are assuming that Congress and the President will at least resolve this with temporary spending measures. This is by no means certain.

Central Bank Neutralization of Threats

Systemic bank uncertainty lay with the sub-prime crisis in 2007 and currently lies with Europe. There was limited transparency regarding the financial institutions holding this debt. In 2007, this led to a domino effect that spread through all the world's financial markets.

In 2007, the Federal Reserve and other global central banks began to adopt a looser monetary policy in response to the sub-prime mortgage crisis. They assumed that the standard monetary response would be effective in containing the crisis and preventing the domino effect described above.

Initially, it appeared to be working. This is what triggered the rally in the latter half of 2007. Then additional problems, such as the bankruptcy of Lehman Brothers, became difficult to contain using standard monetary policy tools.

Monetary policy will need to be loosened even further, including possibly a massive intervention to at least postpone financial Armageddon to a later date. Nothing will be truly resolved, but the game of "kick the can down the road" can continue.

The Prospect for QE3

If the prospects for the economy and fiscal stimulus are so uncertain, what could cause the financial markets to rally? The answer is liquidity. This liquidity has been created by the Federal Reserve along with the other central banks. In addition to the effect on earnings and refinancing mentioned earlier, it also increases the price of risky assets, otherwise known in Wall Street terms as the "Risk Trade."

Many people still view quantitative easing as merely a benefit for the banks and the wealthy, one which adds significant costs for the average individual. In this environment, there may be substantial resistance to a QE3.

However, the composition of the Federal Open Market Committee (FOMC) is changing. The FOMC's most hawkish members, Narayana Kocherlakota of Minneapolis, Richard Fisher of Dallas, and Charles Plosser of Philadelphia, are all losing their votes. These were the dissenters in the last FOMC decision. Their replacements, with the exception of Jeffrey Lacker of Richmond, are all considered to be more dovish. This may make it easier to institute QE3.

The Threshold of Pain

We have seen a familiar pattern in the crisis regarding fiscal and monetary stimulus. As the government institutes some program, we see an economic recovery. Then, when the program ends, the economic figures recede. This is true in cases of spending programs such as infrastructure or tax incentives as well as quantitative easing. The end result is still the same.

The real question becomes the threshold of pain required for the government to institute one of these programs. I have noticed that the level of pain required is lessening as we approach the election year. This is not unique to the current situation and seems to be following the familiar election year cycle.

Forecast: 2012 Will Depend Upon Government Stimulus

If there is not a major shock to the global financial system such as the ones described above, the rally should continue. We should not exceed the spring highs in any case without a government stimulus package.

With regard to 2012, it will depend upon government stimulus. If the Fed acts, we will either be in the trading range or rally higher depending upon the size of the stimulus. Any of the shocks described above could damage the financial system quite substantially. As long as the Fed and the government are able to counteract these threats successfully, the situation may not deteriorate massively.

These threats are significant. If the Fed makes a mistake like 1931 or 1987, serious problems can occur. The United States equity markets are particularly vulnerable since many of the sources and solutions to these problems are largely outside of our control.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.