[Editor’s Note: This special report on the stock market environment that U.S. investors will face in the New Year is part of Money Morning’s annual “Outlook” series, which is reviewing prospects for the U.S. economy, world currencies, oil, gold and other top profit opportunities in 2011.]

The outlook for the U.S. stock market in the New Year figures to be an exasperating mixture of promise and peril.

Positive momentum is building going into 2011, but so are dangerous bubbles.

The high-tech, energy, materials and commodities sectors will be hot in the New Year. And the U.S. stock market will get an added boost from the fact that U.S. Treasuries, municipal bonds (munis) and euro-based investments will not.

Here’s what’s in store for the U.S. stock market in 2011.

Three Little Rules

[ad#Google Adsense]U.S. stock market investors who want to survive and thrive in the New Year would do well to remember three basic rules – each of them born out of the old stock-market adage that “the trend is your friend.”

In 2011, the three rules U.S stock-market investors would do well to remember are:

  • The trend is your friend.
  • And if that trend has momentum, it will be your best friend.
  • But that friendship will only hold until the trend turns on you – at which point it becomes your worst enemy.

The “trend” that we’re referring to here is market liquidity – and lots of it. All this liquidity is washing through the U.S. economy courtesy of the Obama stimulus package, the “quantitative-easing” strategy of the U.S. Federal Reserve, the just-enacted extension of the Bush tax cuts, a cut in payroll taxes, expanded unemployment benefits and accelerated expensing of capital investments in 2011.

A key point to understand about all this liquidity is that “more is always better sooner.” And that’s certainly the case here: We don’t have to wait and worry about getting these simulative measures in 2011 – they’re already in motion.

In this kind of market, fundamentals take a backseat (though they’re not totally irrelevant). Liquidity determines the direction of stocks and other asset prices.

And there could be more liquidity to come.

The Fed’s Plan For a Happy New Year

In a recent appearance on the CBS News “60 Minutes” program, U.S. Federal Reserve Chairman Ben S. Bernanke declared that the already-existing second round of quantitative easing – referred to by the market moniker of “QE2” – could very well be followed by more of the same.

That’s more fuel for the stock-market fire in the New Year.

Liquidity – in all its forms, and all around the world – has been the engine of rising global prices for stocks, bonds, commodities, and even precious metals such as silver and gold.

Much of this liquidity has been stimulus-fueled. The liquidity then drives markets and asset prices higher because most of it ends up being injected into the very pipelines that supply liquidity.

Here in the U.S. market, this is all part of the Fed’s “real” plan to “save” the economy. That central bank plan calls for the central bank to:

  • Liquefy the banks and all the financial intermediaries.
  • Inflate the stock market and create a “wealth effect” where people see stock prices rising and assume the economy is getting stronger.
  • Inflate commodity prices so deflationary fears don’t destroy consumer spending because shoppers put off purchases, rightly reasoning that prices will be lower later.

In other words, the Fed wants to inflate everything, first by devaluing the dollar, the currency in which oil and most major commodities are priced. Then it plans to continue to devalue the dollar by printing money to make our exports cheap on world markets.

Sure, it’s a “liquidity trap,” and a momentum shift in the flood of liquidity is the greatest danger to rising equity prices. But as long as every crisis is met with another massive dose of liquidity, the levy will keep rising, until it eventually breaks.

Long before that happens, however, I’ll have you out of all your longs and will help you start constructing strategic “shorts.” In fact, I’ll have all of you short everything.

That change in direction is what I mean when I refer to the prevailing trend “turning on you,” and becoming your biggest enemy. That will happen when the liquidity is withdrawn.

In the meantime, there’s money to be made through equity investments in different sectors and across different asset classes (courtesy of exchange-traded funds, or ETFs), by going long on positive momentum plays and by shorting some investments about to get the wind knocked out of their sails.

Let’s look at some specifics.

Tapping Into Technology

The brightest stock-market star in 2011 will be tech. Right now, the hot growth areas in the world don’t include the U.S. market. But that’s okay: A research study of high-tech firms in the Standard & Poor’s 500 Index conducted by top-tier market researcher Bespoke Investment Group found that 54% of the gross revenue recorded in 2009 was derived from international markets.

What is spectacular about tech is that technology combines global growth prospects with every company’s need to improve productivity gains through advanced applicable technologies. That’s everywhere. What’s more, here in the U.S. market, a major corporate tax break for capital investments in technology, factories and other equipment will serve as an added tailwind to drive tech sales – and tech stocks – even higher.

U.S. companies are sitting on nearly $2 trillion in cash – their biggest hoard in 51 years. And tech firms boast some of the biggest caches of cash. As a percentage of total assets, their cash holdings are highest among all S&P 500 industry groups. Whether they use their cash to pay dividends, buy back stock, or embark on merger-and-acquisition deals – all of which we’re already seeing – tech-stock investors figure to be the big beneficiaries.

There are plenty of great tech companies and slices of the tech pie. Personally, my favorite trends are cloud computing and data storage. But, maybe the easiest and broadest approach is the best. I like buying the Nasdaq Composite Index in the form of PowerShares QQQ Trust ETF (Nasdaq: QQQQ).

Put a Charge Into Your Portfolio

Energy – specifically oil, the drillers and integrated multinational giants – is poised to soar in the New Year, especially if the emerging markets stay healthy, Europe stabilizes, and the U.S. recovery hits its stride.

With a modicum of inflationary fear back in the spring and summer of 2008, oil rose to more than $145 per barrel. Given the devaluation of the U.S. dollar and rising commodity prices worldwide, crude oil is almost certain to zoom beyond its current trading range at about $85 to $89 a barrel.

The Organization of the Petroleum Exporting Countries (OPEC) has announced a target price of $90 a barrel. Given that oil was trading at $89 yesterday (Tuesday), this looks ridiculously low if demand increases as global economies recover.

ConocoPhillips (NYSE: COP) and Chevron Corp. (NYSE: CVX) are poised to rise handsomely in tandem with the price of oil. So are a few of the drillers, especially the deepwater drillers. Transocean Ltd. (NYSE: RIG), in particular, looks cheap. If the company can escape the worst of the fallout from the Gulf oil spill, it could be a big winner.

Materials, Commodities and Precious Metals Plays

The materials sector is also in good shape to benefit from a U.S. recovery and global growth. S&P 500 materials-based companies derive 45% of their revenue internationally. Rising demand in terms of growing industrial production will put upward pressure on the supply side of materials. I like keeping it simple here and play this big space by buying Materials SPDR ETF (NYSE: XLB).

Commodities investments were once the purview of the high-net-worth investor only. Today, however, every investor needs to have money invested in this crucial sector. We covered oil as part of our energy strategy (and oil, by the way, constitutes a major weighting in most commodities index funds, so be careful not to overweight your portfolio with more “black gold” than you are comfortable with).

Other key commodities groups include agriculture, minerals, livestock and metals (not including precious metals) – of which can be invested in via ETFs.

In agriculture, for example, there is the PowerShares DB Agriculture ETF (NYSE: DBA) and the MarketVectors Agribusiness ETF (NYSE: MOO).

Mostly, I like copper, cocoa, corn and cotton.

For corn, take a look at the Teucrium Corn Fund (NYSE: CORN). If you are an international investor, or have access to the London markets, the ETFS company has a series of ETFs based on the corn futures markets, including the ETFS CORN Fund (LON: CORN.LN).

With cotton, there’s the iPath Dow Jones-AIG Cotton Total Return Sub-Index ETN (NYSE: BAL), which is based on the total return sub-index for cotton. It is based on the return of a single futures contract in cotton.

I also like some of the minerals and metals. There are ETFs for palladium [the ETFS Physical Palladium Fund (NYSE: PALL)] and for platinum [the ETFS Physical Platinum Shares (NYSE: PPLT) ETF]. Platinum, by the way, is a metal whose potential we’ve written about extensively in past issues of Money Morning.

The only caveat to loading up on commodities as we enter 2011 is that they’ve had a big run already and while I expect momentum to continue, there’s a big wild card out there (more on that later) and I suggest either buying small and adding to positions later, or waiting until April to see if the Fed is going to keep the “QE” ship sailing at full speed.

Then there are the precious metals. I like gold, just not in over abundance. A 10% allocation to gold is never going to hurt you and it stands to be a steady winner as long as currency wars and a decimated euro bring the “store of value” discussion to Main Street investors. Money Morning has published special reports on silver and gold investing.

Playing the Downside

As I explained earlier, there is a potential downside when the trend is no longer our friend. And there’s also downward momentum, which comes after upward momentum sputters.

Unless we are headed into another global meltdown or experience a devastating shock to financial markets, bonds have had their ride.

Treasury yields have backed up considerably since QE2 began. While the Fed was trying to keep interest rates low by buying Treasuries and flooding the system with liquidity, bond prices actually fell and yields rose – a lot! If the Fed is successful, or in spite of its efforts, U.S. growth gains traction and global demand for investment capital continues, rates have nowhere to go but up.

Over a trillion dollars have been invested in Treasury bonds since the fall of 2008. That safe harbor isn’t going to look so safe when investors open up their fourth quarter statements and see they have losses in their bond holdings. If stocks keep rising and bond prices keep falling, there will be a capital wave out of bonds that just might upend world stability. We’ll cross that bridge if we get there, but to ride the downward momentum in Treasury bonds I recommend buying ProShares Short 20+ Treasury ETF (NYSE: TBF).

Another mind-bending momentum-mayhem possibility is an exodus of investors from the municipal bond market. There’s no escaping the fact that almost all U.S. states are making ends meet by means of federal handouts. County and municipal governments are almost all out of money and deep in hock.

Rising rates will be the canary in the coal mine, signaling a possible default – or, more likely, several high-profile defaults – if the Fed and the U.S. Treasury Department don’t open up the spigot and keep liquidity flowing into the financial system.

If you’re a muni-bond investor, think about hedging or cashing out. The timing on this one will be difficult, but it’s coming. Because timing on the municipal front is so difficult, I’m not inclined to recommend what to short right now. But I will offer an update on this subject, with specific recommendations, later in 2011.

Lastly, there’s the euro, the currency of the European Union. The euro has been weak lately after bouncing to heights that didn’t make any sense after last summer’s Greek debt woes subsided. What didn’t make sense is that the euro climbed even on the heels of news about Ireland. Not until fears arose that Portugal and Spain could be next to need emergency first aid did the euro start to falter again.

The euro has nowhere to go but down. I like buying three-month-out “calls” on the ProShares UltraShort Euro ETF (NYSE: EUO). This fund is a leveraged, double-short ETF that is designed to move twice as much as the cash market for the euro currency against the dollar. That means that if the euro is falling in value relative to the dollar, EUO will rise in price.

Key Caveats

As we head into 2011 with positive momentum, there are some key warning signals that we need to watch for – since they would serve as warnings of a reversal in momentum. These warning signals include:

  • Any sovereign defaults anywhere in the world.
  • National governments or cross-government unions backing away from debt support and liquidity-supply measures.
  • Or any serious banking or financial markets crises in China.

There are plenty of reasons to be optimistic about 2011, and a few mayhem makers that can turn things upside down.

So just remember this: Your friends are only your friends until you can’t trust them any more.

— Shah Gilani

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Source:  Money Morning