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Where Are Stocks Headed? 6 Potential Game-Changers

Even in normal times, Wall Street stock market forecasts lack precision. These are anything but normal times, what with the euro zone at risk of breaking apart, the U.S. teetering on the edge of the "fiscal cliff" and Democrats and Republicans locked in an election-year feud about how to revive the U.S. economy.

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Given all the uncertainties, the unpredictable outcomes and the unending list of what-ifs facing investors, it's no surprise that drawing an accurate road map to where financial markets are headed the rest of the year is no easy task.

Count Laszlo Birinyi is among the Wall Street players who admit to having a lower degree of confidence in accurately predicting where markets are headed next. Birinyi, president of investment research firm Birinyi Associates, was bullish at the start of the year. And he's still upbeat on the outlook for stocks, saying the Standard & Poor's 500 index could climb to 1,500 by year's end, or 7 percent above Tuesday's close of 1401.35.

But, at the same time, he remains "cautious." The caveat? The risks hanging over the market are too tough to accurately handicap or quantify in a spreadsheet.

"There are too many variables which are beyond our capabilities to absorb and forecast," Birinyi says. One of the most difficult things to gauge is how the eurozone's sovereign debt and banking crisis will play out.

But a lack of visibility doesn't mean investment strategists haven't come up with scenarios that could cause stocks to climb or crater in the second half of 2012. U.S. stocks have rallied nearly 3 percent in the past three sessions and are now up 11.4 percent this year despite all the global headwinds.

Optimists such as Jim Paulsen, chief investment strategist at Wells Capital Management, bet Europe won't blow up, the Chinese economy won't cool too much and the recent U.S. soft patch won't morph into recession. Also, stock prices relative to earnings are attractive, with the market trading at 13 times 2013 earnings forecasts, below the longer-term average of roughly 15. Paulsen also believes a year-end target of 1,500 is a "reasonable expectation" for the S&P 500.

But skeptics such as Joe Kinahan, chief derivatives strategist for TD Ameritrade, say stocks could face downward pressure if things don't play out in a market-friendly way. "It's time to be very cautious. There are so many headwinds."

What'll determine if the market bounces or burns? Here are six potential game-changers in the second half:

1. Fed: Stimulus or No Stimulus?

There is a lot riding on whether the Federal Reserve , led by Chairman Ben Bernanke, will ride to the rescue of markets again by injecting monetary stimulus into the financial system to try to jump-start the economy and boost hiring.

(Investors are hoping for similar moves from central bankers in Europe and the Chinese government to bolster their economies.)

Bernanke has repeatedly said the Fed is prepared to act to boost growth if the pace of economic activity shows little signs of picking up on its own. Since 2009, the stock market has responded favorably to the Fed's innovative programs to ease financial conditions. The Fed's arsenal has included bond-buying programs, as well as pledges to keep short-term rates near 0 percent until late 2014.

Sam Stovall, chief investment strategist at S&P Capital IQ, says more stimulus is coming. (Most Wall Street pros say it's needed.) The only question is when. Stovall says the "anticipation of stimulus" is acting like a floor under stock prices.

"The Fed," he says, "has one bullet left, and they want to wait as long as possible to use it."

The Fed's next policy meeting is Sept. 12-13. If the central bank fails to announce a new round of stimulus, as it did after its recently concluded August meeting, markets could be disappointed.

2. Election: Obama or Romney?

The run-up to the presidential election is a time of great uncertainty, as it's tough for investors to gain any strong insight into which policies might be put in place until a likely winner emerges.

The final makeup of Congress is also critical to the policy puzzle. The balance of legislative power can shift dramatically if one party gains control of both branches of Congress. (The Republicans, who now control the House of Representatives, have a 50/50 shot in November of seizing power in the Senate, too, according to Intrade, an online prediction market.)

"The presidential election results are intertwined with the markets and the economy," wrote LPL Financial's chief market strategist Jeffrey Kleintop in a report titled "Campaign 2012: What the Elections Hold for Investors." "The economy is affected by fiscal, monetary and regulatory policy — all of which are influenced by the election winner."

Which tax laws, trade policies and banking regulations get enacted could differ markedly if the Republicans sweep the White House and Congress, or if President Obama wins a second term but must deal with a Republican-controlled Congress.

Since World War II, stocks have suffered losses only three times in election years, according to LPL. Rallies tend to get stronger as Election Day nears and policy clarity improves.

The S&P 500 has risen 81 percent of the time since 1944 in the fourth quarter of election years, says S&P Capital IQ.

This year's elections are particularly important. Lawmakers are under great pressure to come up with a fix for the nation's crushing debt load or risk another credit downgrade from ratings agencies — and a vote of no-confidence from investors. Congress also must act to avoid the U.S. falling over the so-called fiscal cliff, a growth-crimping combination of higher taxes and spending cuts.

3. Fiscal Cliff: Over the Edge or Close Call?

A budget bombshell is looming on Jan. 1, 2013, when — barring a vote by a deeply divided Congress to extend them — the Bush tax cuts and temporary payroll tax cuts will expire. Nearly $100 billion in automatic government spending cuts also kick in.

All told, the economy could be hit with a fiscal drag of more than $500 billion, or roughly 3.5 percent of GDP , the Congressional Budget Office says.

"The approaching fiscal cliff is big, scary, yet avoidable," says Bill Stone, chief investment strategist at PNC.

It must be avoided if the economy and markets are to avoid harm. The CBO says falling off the fiscal cliff would cause a recession in the U.S. in the first half of 2013. It would also cause turbulence in financial markets, and damage consumer and business confidence, as well as reduce profits earned by U.S. companies.

Those negative outcomes are a big reason Wall Street expects lawmakers to compromise to avoid fiscal-cliff pain.

But a deal might not be struck until after the election, says Daniel Clifton, a policy analyst at Strategas Research Partners.

Whither Europe?

4. Europe: Break Up or Make Up?

If there's one thing that keeps Birinyi up at night, it's Europe: He doesn't know how the debt crisis will end. Can the European Central Bank save the day? What happens if Greece exits the eurozone? Will it cause a domino effect and push bigger economies with high debt loads, such as Spain and Italy, to seek bailouts of their own?

"How it unfolds and when it unfolds, I am not even going to try to forecast," says Birinyi.

The fact that global stock markets swooned on July 20 after the Valencia region of Spain asked the government for financial assistance, only to rebound sharply a week later when the head of the ECB, Mario Draghi, said he would do "whatever it takes" to save the euro, shows how unpredictable the crisis is.

"I never thought I would have to worry about a region of Spain," says Birinyi. "It is irresponsible to say that (a bad outcome in Europe) is priced into the market. It is not."

5. Policymakers: Fix It or Make It Worse?

The fate of markets for the remainder of the year will be dominated by three factors: "policy, policy and policy," says Ewen Cameron Watt, chief investment strategist for BlackRock Investment Institute.

A policy mistake in the USA, which faces key decisions on taxes and ways to bolster growth while also trimming the ballooning budget deficit, would be a market negative. A failure of European lawmakers and bankers to end the debt crisis and halt financial contagion would also be bearish, as would China's inability to manufacture a soft landing for its once-booming economy.

"Everything," says Cameron Watt, "is in the hands of the politicians."

Topping the U.S. policy agenda? Coming up with a tax policy fix that promotes economic growth and reduces uncertainty for businesses, says Andy Busch, a public policy strategist at BMO Capital Markets. The goal: come up with a long-term solution that will give businesses the confidence to invest and hire new workers.

"You can't have a government that operates on a quarter-to-quarter basis when businesses require confidence to go forward with a new plant that will take three years to build," Busch says.

6. China: Hard or Soft Landing?

China is the world's second-biggest economy. It's also been the engine of recovery since the financial crisis. A hard landing, or severe economic slowdown, is the last thing investors want to see.

The good news? China's attempts so far to reinvigorate its economy via two interest rate cuts appear to be working. In a recent report, the International Monetary Fund said China is headed toward a "soft landing." It expects the Chinese economy to grow 8.5 percent in 2013, up from 8 percent now. The IMF also stressed that, like the Fed and ECB, China is prepared to do what is necessary to keep its economy strong.

The fact the stimulus is working is a huge relief, says Paulsen.

"To me, the world can go on with a flat-lining Europe," he says. "But if the emerging world falls into recession, the global recovery is over."

Investors should keep the faith, says Stuart Freeman, chief equity strategist at Wells Fargo Advisors. Working in favor of investors, he says, are signs of stabilization in the housing market, lower gas prices and depressed stock valuations.

"Right now, the market is assuming that all of the negatives will all work against us," Freeman says. But he says the odds are that not every worst-case scenario will come to fruition.

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