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In December we wrote an article called Are We Due For Another Global Recession? We argue in this article that the probability of a mild recession toward the end of 2012 is high. In this current article, we revisit this prediction given new information and explore the possible scenarios for the U.S. stock market in 2012.

For those who have not read our articles we make macro predictions based on indicators developed from insights on investor psychology. This article centers around the indicator we developed for the U.S. equity market. A low number signifies bullish sentiment and a high number bearish sentiment. If the indicator value crosses its crisis threshold, it signifies a crisis is imminent. Our history goes back to 1970.

Since 1970 there have been five incidences when the U.S. behavioral indicator made a significant movement from a low value to a high value just under our crisis threshold. One of these five occasions includes August 2011 to the present.

The onset of the significant increase in the indicator for the four prior periods include, 1971, 1979, 1986, and 2006. In all four of the prior cases we have found an interesting result. Once the period of the significant increase ends by touching the crisis threshold, the U.S. stock market was positive for the following year. However, once the year ends, the U.S. stock market declined 15-30%. This time line is approximately the same for all four cases. At the end of November, 2011, the U.S. behavioral indicator touched the crisis threshold. If the current case follows the four prior cases, we expect a similar positive return from November 2011 to the end of October 2012 as in the four prior periods. Let's take us take a look at the annual return of the four prior cases once the indicator hits the crisis threshold.

Table 1: Return

Assuming that the 2012 return corresponds to the returns above, we should expect high return for the majority of 2012. Therefore, we are bullish for the U.S. stock market in 2012 up until November.

Why November? Once the years noted above ended, the stock market declined in all four instances. What did the returns look like once the year ended.

Table 2

In all four cases there were subsequent negative returns. Of all the four prior periods, today is most similar to 1979 or 1986. For the 1972-1973 and 2007 years the decline was slow over six months. Then large crises ensued. For 1980 and 1987 the decline was quick and then a large rebound occurred.

Given the dynamics of the current 2011-2012 indicator, we believe the this current cycle is more closely related to 1979-1980 and 1986-1987. Therefore, the thing to watch out for is the annual return for the U.S. stock market going into October of 2012. If the return is around 20%, we then predict a 15% decline in the following two months. If the return is between 30-40% or more, we then would predict a larger decline over two to three months.

In conclusion, we recommend to be fully invested for 2012. Invest in U.S. stock market ETFs such as the S%P 500 (NYSEARCA:SPY) or Dow Jones ETF (NYSEARCA:DIA).

However, we believe one needs to watch the timeline and return of the S&P 500. In all four previous cases it took a year and half from the onset of the significant change in our U.S. indicator for another sharp decline to occur. Even so, patterns and history never repeat exactly all the time. Therefore, we recommend to watch out for the return of the S&P 500. If there is a 20% positive return in the next six to nine months, then we suggest hedging for a 15% decline. If the return is closer to 30% over the next six to nine months, we suggest hedging for a larger decline. One can use inverse ETFs such as SH.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Why Investors Should Be Fully Invested In U.S. Markets For 2012