What do financial markets have in store for 2012?

When one of the world’s most experienced money managers talks of “paranormal” activity in today’s markets, you know these are treacherous times for average investors. “It’s as if the Earth now has two moons instead of one,” mused Bill Gross in his first investment letter of 2012. Gross, the head of a $244-billion bond fund at Pimco, one of the world’s biggest fund managers, lost $5 billion in redemptions last year, as clients pulled money out of his fund after a string of bad (but at the time seemingly rational) bets against U.S. Treasuries.

If not paranormal, 2011 was the year when volatility went viral. Bad luck played a part, with large swaths of the Japanese economy swept away by the tsunami. Mostly, though, the uncertainty that rattled investors was man-made, as bickering policy-makers in Brussels and Washington seemed to gamble with the fate of the global economic recovery. Stocks on the Standard and Poor’s 500 Index swung twice as much as they did, on average, in the last 50 years, only to close roughly where they had opened 12 months earlier, according to Bloomberg. The Dow Jones Industrial Average closed up by just six per cent, and the NASDAQ went down two per cent. Even more disappointing was the TSX, which closed the year down by 11 per cent.

Gross wasn’t the only pro who faltered in a year when, in addition to wild volatility, market activity slowed. U.S. broker-dealer MF Global Holdings Ltd. went belly up in November after betting $6.3 billion on European sovereign bonds. Last October, Goldman Sachs posted its first quarterly loss since 2008. Eager to protect profits and reputations, some financial firms are resorting to desperate measures—Dutch Bank ABN AMRO even introduced a tool called the Rationalizer, which measures emotional arousal levels through skin sensors and advises traders to take a break or wind down their transactions if they get too elated or frustrated. All this raises a troubling question: what chance does the average investor stand? Even those who played it safe by turning to things like guaranteed investment certificates and principal-guaranteeing investment vehicles were left languishing. With interest rates at near-zero levels, baby boomers are approaching retirement with unexpectedly undersized nest eggs. Mounting resentment against financial advisers, meanwhile, had Canadians choosing to try to go it alone. The number of accounts registered with online brokerages has increased by 36 per cent since 2008, according to Investor Economics, a Canadian financial services research company.

By most accounts, 2012 is poised to be just as difficult as last year, given the lingering uncertainty about European economies and the sputtering global recovery. But economists and advisers still see some reason for optimism, and no reason to sit still or be scared. As Warren Buffett famously said: “Be fearful when others are greedy, and be greedy when others are fearful.” This year, then, may well be the time to risk a little bit again.

A number of experts see the potential for growth in the United States. Eric Lascelles, chief economist of global asset management at the Royal Bank of Canada, says he is “cautiously optimistic” about the recovery south of the border. Recent data supports investors’ higher hopes in Uncle Sam. According to the Manufacturing ISM report, manufacturing activity across the U.S. had its 29th consecutive month of growth last December. Confidence among small businesses was also pointing upward in December, for the fourth straight month. And, crucially, unemployment has finally started to fall. Most importantly, U.S. corporate profits have been steadily rising since 2010. After plummeting between 2007 and 2009, they reached a record $1.97 trillion before taxes in the third quarter of 2011, according to the latest data by the U.S. Department of Commerce.

So far, little of that money has been feeding back into the economy, says Ian Russell, president and CEO of the Investment Industry Association of Canada (IIAC). Concerns about teetering global growth and uncertainty at home have discouraged corporations from translating their healthy balance sheets into capital investment, he explains. It’s bad news for America’s unemployed, but good news for investors holding blue-chip, dividend-yielding stocks. With so much cash idling in companies’ coffers, corporations are likely to pass on more earnings to shareholders. Standard and Poor’s expects the dividend yield of its S&P 500 index to grow by 11 per cent this year.

For those feeling skittish about holding equities, there are still attractive picks in the fixed income market, says Mark Neill, head of PH&N Investment Services, a Vancouver-based investment management firm that is part of RBC’s Global Asset Management. There are a number of good-looking high-yield corporate bonds tied to U.S. and Canadian companies, especially those with exposure to emerging markets. Yes, we’re talking about so-called “junk bonds.” But don’t let the term scare you, says Neill. “Some of these bonds, among the ones rated B and higher, are good enough quality.” They’re a solid alternative to the low-yield government bonds that crowd most Canadians’ portfolios, he adds.

Others like bets on companies that will be largely unaffected by a potential slowdown in global growth, whether it’s in equities or debt. As the IIAC’s Russell sees it, two trends are almost certain to carry through 2012 and the foreseeable future: emerging markets will continue to add to the global middle class, and developed economies will add to the ranks of seniors and retirees. There are opportunities in both trends. As an ever-larger share of the world’s population can afford not to go hungry, for example, companies tied to shifting global food patterns have become financial markets champions. Take agricultural equipment manufacturer John Deere, whose net income per share grew by over 50 per cent in fiscal 2011 from a year earlier; or food-maker Kraft Foods, which was one of the leading performers among the 30 components on the Dow, with gains in the value of its class A shares of about 23 per cent from a year earlier. Other big winners were health care stocks, which rose by 13 per cent through the year, led by pharmaceutical giant Pfizer Inc., according to Bloomberg. Aging baby boomers may represent one of the few sources of fat profit from Europe, quips Russell.

Still, don’t expect smooth sailing in 2012. The volatility that dominated 2011 could well continue. Policy-makers on both sides of the Atlantic will, in all likelihood, keep driving fearful market movements, “and they are unpredictable,” warns RBC’s Lascelles. In Europe, a collapse of the common currency seems more unlikely—though it’s not impossible—adds Russell, but European lawmakers will probably continue to rush through patch-up measures to calm the markets when investors become jittery. They will likely postpone as long as possible the “bazooka approach” to fiscal policy (like the massive bailout launched by the U.S. Federal Reserve in 2008) needed to put the European Union on a stronger footing. The consensus? Expect a continent-wide recession.

Similarly, in Washington, the looming presidential election will only exacerbate the partisan divide that paralyzed Congress throughout 2011, and caused the U.S. to lose its Triple-A credit rating last summer. “They will continually run into debt ceilings and create mini- crises,” preventing the economy from reaching its growth potential, predicts Russell.

Meanwhile, Canada, after much talk about its standout growth in recent years, may have finally maxed out (or at least lost some of its appeal among investors). “Home ownership and consumer borrowing are at record highs, the resource sector is slowing down,” muses Murray Leith, VP and director of investment research at Odlum Brown Ltd., a Vancouver-based investment management firm. And according to Bank of America Merrill Lynch, this will be the year when our housing market finally starts to deflate—albeit gradually, with housing investment most likely contracting by a moderate five per cent in the first six months.

Financial advisers continue to advise caution. The usual arsenal of common sense recommendations still applies: make sure you know what you own, that your portfolio doesn’t look like the TSX, and that you’re well diversified. In sum, it may be fine to dip your toes back into the markets—but pick your entry points carefully and don’t dive in blind.