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Kevin Fusco: Fresh start for the economy, equity markets

As the millions of Americans who recently devised resolutions will tell you, the new year offers a fresh start. It offers an opportunity to correct the mistakes of the previous year, or set forth on a better path, or even just build on last year’s successful resolution, if you were one of the few who actually kept it going all year long.

Although the turning of the calendar means very little to the economy and financial markets from a fundamental standpoint, it does provide the opportunity for investors to reset their expectations and revise their investment strategies with a “fresh start” in mind.

What investors find in 2012, though, may be very similar to what was left behind in 2011, and that may not be a bad thing at all. The year ended on an upswing in positive economic data that should continue into the New Year, and more than likely keeps us out of recession.

This is not to say that the domestic economy will catch fire in 2012, but a steady 2 percent growth rate, while sluggish, is still reasonable if recent business cycle behavior holds true. Since 1950, the average business cycle has lasted five years, which would mean that the current cycle won’t reset until 2015.

Many investors feel that the current business cycle will not reach its expected duration, and fear that a return to recession in 2012 is inevitable. This sentiment, while somewhat at odds with recent performance, does have validity, and is generally based on three major factors seen as the biggest threats to economic expansion: a lack of job growth, a rise in inflation, and fiscal budget and debt concerns both here in the U.S. and overseas.

Unemployment still remains at elevated levels, but the economy has been able to recover roughly 2.6 million of the estimated 8.9 million jobs that were lost during the Great Recession. The pace is not speedy by any account, but positive job growth has been constant since early 2010 and should continue at a pace of almost 150,000 private sector jobs added per month in 2012.

Inflationary pressures are sure to mount by the end of 2012, but not to the hyper-inflation levels of the mid-1970s or early 1980s. Actually, a modest increase in inflation would be healthy for the economy, and would further assuage fears of deflation, which most would argue is far more dangerous than small, incremental increases in prices. Rising commodity prices, a falling dollar, and the effect of monetary stimulus could push inflation closer to 4 percent by year-end, but this still would not threaten a 2 percent GDP growth rate.

The current federal budget deficit is unsustainable, and will lead to the largest shift in fiscal policy since the end of World War II. The outcomes of both the presidential and congressional races will be closely contested, and there is the possibility for sweeping changes to the political landscape, or not much change at all.

Regardless, compromise that eluded politicians in 2011 must be found in 2012 to avoid another domestic debt downgrade, and the fear of this facet alone may be enough to motivate politicians to action. Of the three main risks to economic growth in 2012, fiscal concerns pose the biggest threat, but should not derail expansion at modest levels.

Investors should also use the new year as a reason to decouple their expectations for the equity markets in 2012 from how they believe the economy is going to perform.

Even if any of the three aforementioned risks, or even an intangible that was not addressed, threaten to slow economic growth, it is important to keep in mind that the factors that drive earnings, and thus, equity growth are different than the components that drive GDP. In fact, over the past 40 years, the median return of the S&P 500 index is roughly 10 percent when real GDP grows less than 3 percent.

Whether the major equity indexes garner a double-digit gain in 2012 will be dependent on numerous factors, but many of them are either in good standing, or are pointed in the right direction. Valuations can’t be ignored for too long, and a continuation of the positive economic reports, combined with a strong fourth-quarter earnings season, may propel equity market performance over the winter months.

Kevin Fusco is senior vice president of Fusco Financial Associates Inc. of Towson. He can be reached at 410-296-5400, extension 109, or Kevin.Fusco@LPL.com.