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After making solid gains in 2012, stocks are off to an impressive start in 2013. Many expect the momentum to continue, giving us gains comparable to what we got in 2012. Driving this optimism is a combination of the improving domestic housing scene, a less worrisome Europe and signs of life in the China growth story.

With the fiscal uncertainties far from addressed, one would have expected investors to be a lot gloomier in their outlooks. But that's not what we see in the market.

So is that it? Should we find assurance in the market's recent price action and stop worrying about the U.S. and world economy? After all the Fed is on the case, and nothing could go wrong when it stands ready to keep interest rates down.

All of this sounds quite plausible, but I don't buy it. My reading of the ground realities leaves me reasonably confident that the market will be giving back most, if not all, of its 2012 gains in the coming year.

Professional forecasters have been hoping for a second-half GDP recovery each of the last three years, and this year has been no exception. But we always had corporate earnings to fall back on when the 'second-half recovery' wouldn't show up. Unfortunately for us, the earnings cycle is over and wouldn't be available to prop stocks up this year.

I am not making a recession call, though I do envision a far tougher environment for the market indexes than was the case in 2012. And while there will still be plenty of profitable investment opportunities in the stock market in 2013, the overall orientation of your portfolio should be defensive. Such a posture may not get you home runs in the market, but you wouldn't have to lose sleep over your capital either.

A Look at the Fundamentals

Here are reasons why I find it difficult to buy into the 'all-is-good' consensus narrative.

A) U.S. economy – Muddle-through Growth at best: It is hard to say anything positive about the U.S. economy outside of the housing sector. But the housing gains are barely enough to offset the weakness in the factory sector and corporate capital spending. The economy expanded at a +3.1% pace in the third quarter, but will barely achieve half that growth pace in the current and following quarters. The consensus expectation is for a second-half growth ramp again this year, just like it has been looking for at the start of each of the last three years. With some sort of austerity getting underway as a result of the deferred 'Fiscal Cliff' resolution, the second-half recovery expectation may be nothing more than just a 'hope'.

B) Europe – Together in Sickness: While the U.S. economy should continue to 'muddle through', we can't say the same about Europe. The region has made some progress in tackling the existential threats to the currency union. That is no small achievement, but the region's economic fortunes are steadily moving downhill, with the periphery problems slowly seeping into the 'core', as recent softening data out of Germany bears out. While the consensus view is for 'no growth' in the region in 2013, the most likely scenario is for it to remain in recessionary territory.

C) China May Not Have a Hard Landing, But They Aren't a Growth Engine Either: China's case is somewhat different relative to the U.S. and Europe since they have the capacity to prop their economy. Recent trade, industrial production and electricity generation data shows that the deceleration trend may have started easing. But while the 'hard landing scenario' may no longer be the outcome, the double-digit GDP growth rates of years past may not be coming back either. In fact, it is hard to envision the country sustaining GDP growth in the 7% to 8% vicinity without domestic consumption becoming a bigger piece of the economy, and given the growth outlook for Europe and the U.S.

D) Corporate Earnings – 'Hoping for the Best': Estimates for the fourth quarter earnings season have come down from the roughly +8% growth expected a few months back to barely in positive territory. What this means is that earnings growth was essentially flat in the second half of 2012. But expectations are for a turnaround in 2013, with total earnings expected to grow in the low double digits. Count me as skeptical of these forecasts. With margins already peaked and growth a problem all over the world, these expectations may not be much different than 'hoping for the best'.

Putting It All Together

Given how low the hurdle is this earnings season, it will not take much for companies to come out with positive surprises. As such, it is fairly reasonable to assume that the ratio of companies beating expectations will be higher than what we saw in the third quarter. But that will likely not matter much this time around.

As I mentioned here last week, the quality of company guidance will determine how good this earnings season actually turns out. I am of the view that estimates for 2013 will start coming down as the fourth quarter reporting season unfolds. A more reasonable estimate for earnings growth this year is in the low single digits, materially below current expectations. The negative earnings revisions will most likely emerge as a major problem for the market rally, even before the looming debt ceiling debate takes center stage.

Focus List Update

We made four changes to the Focus List portfolio this week – adding and deleting two stocks each.

We exited our long-standing position in Apple (AAPL - Free Report) following reports of a weaker looking outlook for iPhone 5. I had been concerned about the emerging trend of negative estimate revisions for Apple in recent weeks, but was still hesitant to get out of the oldest position on the Focus List (Apple shares entered the Focus List in November 2009). Steve Reitmeister's decision to partly exit the Apple position in his trading service gave me the 'nudge' to follow suit. I still like the Apple story and would not be against revisiting it in future, but I consider it appropriate to book the roughly 163% gain in this stock at this stage. We also exited the profitable Cabela's (CAB) position because it fell to Zack Rank #4 (Sell).

Replacing these two stocks, we are adding Equifax (EFX - Free Report) and Apogee Enterprises (APOG - Free Report) . Equifax is the consumer credit bureau company that gives us exposure to the improving, albeit slowly, consumer credit and housing markets. The company is primarily U.S. centric, with 75% of revenue coming from the home market. Importantly, this Zacks Rank #1 (Strong Buy) stock pays a 1.3% dividend. Apogee designs and develops glass products, services and systems and gives us exposure to the improving commercial construction markets. While this Zacks Rank #2 (Buy) stock has had an impressive run in the recent past, it still has plenty of upside potential. Apogee also pays a dividend, currently yielding 1.5%.

In-Depth Zacks Research for the Tickers Above

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Equifax, Inc. (EFX) - free report >>

Apogee Enterprises, Inc. (APOG) - free report >>

Apple Inc. (AAPL) - free report >>

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