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Stocks have sustained the positive momentum from 2012 and reached multi-year highs in recent days. The Friday announcement of a three-month extension to the debt ceiling and its decoupling from the budget issues likely provides a further optimistic backdrop for stock market bulls. Flows into equity mutual funds also appear to have turned around in recent days, raising hopes that the long expected rotation out of fixed income assets may have finally gotten underway.

The CBOE VIX Index, generally considered a good proxy for market anxieties, fell to its lowest level on Friday in more than 5 years. Some have started wondering if the VIX Index is on course to get back into the single digits, where it was in 2006.

The chart below plots the divergent paths of the S&P 500 and the VIX indexes over the past year.

Driving the optimism is a combination of positive domestic and international economic data in recent weeks and the sense that the worst may finally be behind us on the European question.

On the home front, housing appears to be gaining momentum, which should have beneficial effects in a host of other economic areas. The Fed remains supportive, notwithstanding recent counter moves in the bond market. Internationally, China seems to have turned the corner and does not appear headed towards a hard landing as many feared some time back. And the Euro-zone's implosion fears have eased considerably since the start of the European Central Bank's OMT program, as the persistent downtrend in Italian and Spanish government bond yields over the last few months confirm.

I may not be as optimistic in my near-term outlook as many of the stock market bulls, but I am no party pooper either. I am a strong believer in being fully invested in the market all the time and am enjoying the market's ever higher march as much as the next investor.

But as infectious as the current bout of optimism may be, I would be remiss in my duties if I didn't highlight a few very obvious red flags.

1) Be Wary of Second-half U.S. Recovery Forecasts: Wall Street practitioners of the 'dismal science' are eternal optimists. They always see a 'strong' recovery taking hold in the back half of the year, and this year is no different. The consensus expectation is for GDP growth to reach close to 3% in the second half of 2013, after a growth pace that is less than half that level in the current and last quarters.

Housing should no doubt be a bigger growth contributor this year, but that may be more than offset by softness in manufacturing and some give back in consumer spending following the sunset of the payroll tax cut. Bottom line, GDP growth in the second half most likely will be no different than the sub-2% pace we should see in the first half.

2) Not Many International Growth Spots Either: China's better-than-expected fourth quarter GDP report seems to confirm the trend emerging from other high-frequency economic data lately, indicating that the deceleration trend may have started easing already. This does not mean, however, that we can start looking ahead to the double-digit GDP growth rates that we typically associate with China. 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.

Europe no doubt seems to have turned the corner, with Mario Monti's OMT program bringing down the borrowing costs for Italy and Spain. But the region's economic fortunes are steadily moving downhill, with the periphery's 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.

3) The Earnings Growth Story May have Played out Already: The fourth quarter earnings season currently underway is modestly better relative to the third quarter. But that's hardly any consolation given how weak actual earnings growth was in the third quarter. While earnings growth in the fourth quarter will likely reach the +2% pace compared to the flat finish in the third quarter, the expectation is for a significant ramp up in growth in the back half of the year. In fact, just like the GDP growth expectations referred to above, most of the corporate earnings growth in 2013 is also coming from the same period.

Earnings estimates for 2013 have started coming down a bit lately, but they still represent a significant growth from 2012's low single-digit growth pace. The second half growth ramp up is expected to carry into 2014, resulting in double-digit earnings growth next year. These earnings growth expectations reflect strong gains on the revenue front and some additional improvement from margin expansion. The revenue growth expectation in turn is a function of economic forecasts that call for above-trend growth resuming in the second half of the year. I am very skeptical of these expectations and would be pleasantly surprised if we get any earnings growth above low single digits this year and next.

Putting It All Together

It is reasonable to be skeptical of the narrative for improving fundamentals and second-half recoveries, which is pushing stocks to multi-year highs and volatility to multi-year lows. This doesn't mean that you exit the market, but rather that you defensively position your portfolio to be ready for the eventual onset of reality.

What this means is that you lighten up on economically sensitive sectors/industries and expose yourself to industries/companies that don't rely on above-trend economic growth to generate outperformance. You will likely miss out on some upside potential should the optimistic outlook reflected in current market prices turn out be true. But you will be saving yourself from a lot of trouble in every other potential outcome. It pays to be skeptical.

Focus List Update

We are making two changes to the Focus List this week – adding and deleting one stock each.

We are adding Wisconsin Energy Corp. (WEC - Free Report) , the Milwaukee-based regulated electric and natural gas utility. It currently has a Zacks Rank #1 (Strong Buy) and pays a growing dividend currently yielding 3.6%. The company recently announced a 13% increase in quarterly dividend to the annualized rate of $1.36 per share and reaffirmed its plan to raise its payout ratio to 60% in 2014 and 65% to 70% by 2017. With most of its capital spending plans already behind it, the utility remains well positioned to grow its dividend in the 6% to 8% range over the next few years.

We are deleting Lender Processing Services (LPS) as the stock fell to a Zacks Rank #4 (Sell). I am also closely monitoring MarkWest Energy Partners (MWE) and PS Business Parks (PSB) that have equivalent Zacks Ranks. The key reason for 'tolerating' those other stocks is that earnings are a lot less material for MLPs (MWE) and REITs (PSB) compared to regular companies. That said, earnings, nevertheless, have cash flow implications and we need to be careful when evaluating negative earnings trends for these cash flow centric stocks.

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