How the Second Half of 2012 Will Play Out (Hint: Ugly), and Where to Invest

By Jay Pelosky

NEW YORK ( Minyanville) -- Investing is, in large part, deciding when, where, and how to take risk and get paid for it.

The post 2008 risk-taking environment has been uncertain at best, an environment mirrored in 2012. Government intervention, asset price fluctuation, and sub-par global economic growth have combined to shrink trading volumes and increase volatility across assets. Within a long-term portfolio, tactical decision-making has assumed greater importance. Taken together, these effects have led investors on a search for the Holy Grail of investing: high single digit returns with low volatility.

While there is no halftime in investing, we approach the second half of 2012 and investing conditions look ugly.

Europe remains a mess, emerging markets suffer stagflation, commodity investors question the super cycle, equities soar then swoon, and bond yields shrink in safe havens while rising in ever-wider parts of Europe. US financial assets: the dollar, Treasuries and equities, have remained safe havens leading to significant outperformance. Through May, US equities have outperformed the rest of the world by roughly 800 bps and emerging market equities by 500 bps.

Here is how I see the second half playing out.

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European outcomes remain polarized between closer integration and dissolution. Greece is effectively discounted with very little private sector money involved; its risk now resides in an exit from the euro and what that might mean for Spanish euros, Italian euros and the rest of Europe. Spain is likely to need a bailout soon while Germany continues to resist spending more money. Germany remains Europe's lead actor and what it desires is a weak currency within a large trading bloc, suggesting that at some point it will do as the others wish. Market pressures have risen sharply; ECB and perhaps IMF action could be imminent. One thing is certain: The longer the brinkmanship between the ECB and Europe's politicians lasts, the weaker European growth will be -- not only in 2012, but in 2013 and beyond.

A principal question for investors is whether US equity performance is sustainable in the second half. I have my doubts. The main US equity risk for 2012 remains earnings driven. With second half S&P earnings forecast to grow 12% y/y and 2013 earnings forecast to grow another 10% there is more than ample room for earnings disappointments. Investors and analysts tend to focus their thinking toward the out year once June and Q2 earnings come through. Earnings have been key to maintaining equity price levels - that support will be called into question in the second half.