The market has been less volatile than expected so far this year. But it could get a lot riskier in the months to come. Here's what to watch for, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

Where does the stock market go from here? For those of us who started the year skeptical, is it time to abandon our skepticism and jump in whole hog? For those of us who have caught all or much of the rally, is it time to start taking profits or is the best course to stand pat?

I ended 2011 and started 2012 saying that I thought the first half of 2012 would be scarily volatile, and investors should keep their powder dry for a second-half rally after the People's Bank of China cut interest rates. Wrong, as of seven weeks into 2012.

About two weeks ago, I opined that the rally now under way would run through February 29-when the European Central Bank offered European banks an additional ?1 trillion in loans. Until then, I said, it was safe to play the rally. After that, the odds of a correction would increase. Is that still true?

Let me give you my take on where we are now and what moves are most likely to result in good returns at less than market risk.

A Worldwide Rally
The US market has turned in a stunning beginning-of-the-year rally. The S&P 500 had returned 8.56% as of Friday, February 17. The small-company stock Russell 2000 Index has crushed even that return. That index is up 11.97% through February 17.

The rally isn't limited to US markets, either. The iShares MSCI Brazil Index (EWZ) is up 19.78% through February 17. The iShares FTSE China 25 Index Fund (FXI) is up 15.46% for the same period.

Hey, even the European and Japanese markets are up big time year-to-date. The iShares MSCI EAFE Index Fund (EFA), which has 85% of its portfolio in Europe and Japan, is up 10.07% through February 17.

In other words, this rally has been worldwide. Which, it turns out, offers some pretty important clues for why the market has behaved as it has so far in 2012.

First, we've had a rerun of the risk-on trade that formed half of the risk-on/risk-off pattern that dominated 2011. In the beginning of 2012, investors felt comfortable taking on more risk because the two big dangers left over from 2011 seemed less threatening.

Europe Stabilizing
First, Europe seems less likely to blow up.

I don't mean that the Greek crisis was resolved, fixed, solved or whatever. In fact, during the past few weeks European politicians have practiced a degree of brinkmanship that is truly scary. A Greek default in March has seemed a careless word or a misplaced decimal point away. (For my take, see "What happens if Greece goes bust?")

But the huge ?489 billion in three-year loans extended by the ECB in December to European banks, and the prospect of as much as an additional ?1 trillion in lending in a second facility on February 29, made it far less likely, in the market's opinion, that a Greek default would take down the European banking system.

It also reduced the risk that an unexpected failure of a European bank or two would blow up a systemically important bank somewhere else (such as in the United States). A market that's worried about the end of the world has a pretty low threshold for good news.

Second, the global economy seems less likely to sink into a recession. Sure, Europe is headed there, but the US economy grew by 2.8% in the fourth quarter of 2011, and the Federal Reserve has promised to keep interest rates at their current extraordinarily low level through the end of 2014.

Other central banks have unleashed their own stimulus packages on the world economy. The Banco Central do Brasil has been cutting interest rates since August. The People's Bank of China lowered reserve requirements again on February 18.

Meanwhile, the Bank of Japan announced an expansion of its plan to purchase debt instruments. And then there's all the money that the European Central Bank has pumped into the Eurozone economies with its purchase of Italian and Spanish government debt and its bank lending facility.

There's no guarantee that this river of cash will stop the slowdown in the world economy short of real pain, but growth prospects in both the US and Brazil improved in recent government numbers, and in China it's increasingly clear that the government has embarked on a policy of monetary stimulus.

I think that all adds up to a reasonable explanation for why global stock markets have rallied so dramatically. But what we're interested in now is not where the stock market has been but where it may be headed.

Remaining Questions in 2012
Of course, no one knows what will happen in the remainder of 2012. Will official US unemployment sink to 7.8% by June?

Will the spike to 4.5% inflation in China in January turn out to be, as I believe, a side effect of the timing of the Lunar New Year in 2012 (more on this later)? Or does it signal a revival of inflation that will derail an interest rate cut in June or July?

Will the New Democracy party win an unexpectedly big majority in the April election in Greece and repudiate the recently negotiated austerity package?

I don't know; no one can be certain.

What we can do as investors is assess what the market now anticipates-what is baked into stock prices-and assess, to the best of our ability, the odds that what the market anticipates will actually occur.

So, for example, the US and global stock markets anticipate accelerating growth in the US economy. That's much more optimistic than the Federal Reserve's forecast. On February 15, the Fed lowered its estimate for growth of US gross domestic product in 2012 to 2.2% to 2.7%. That's down from a November estimate of 2.5% to 2.9% for 2012.

The reading from the Organisation for Economic Co-operation and Development, on the other hand, is more mixed-which is good news. In December the developed economies' think tank upgraded growth prospects for Japan and the United States but downgraded growth prospects for China, Brazil and Eurozone economies.

NEXT: US Growth Expected


US Growth Expected
How much growth is the stock market anticipating from the United States? Somewhere between the 2.8% growth in the fourth quarter of last year and the heady 4.4% growth projected by International Strategy and Investment, a forecasting firm that employs respected Wall Street economists Ed Hyman and Dick Rippe.

ISI believes recent data on initial claims for unemployment and retail sales point to a sharp acceleration in growth in the first quarter.

My advice is to watch Wall Street economists carefully. If more of them start talking about 3.5% or better growth in the quarter, that would be good for stocks in the short term. But it would also raise the risk of a disappointment when we get first-quarter GDP numbers in April.

GDP growth doesn't translate into earnings growth in any straightforward way. And the earnings picture is what worries me most about the US stock market.

Earnings growth for the companies in the S&P 500 index that have reported as of February 17 is at just 6.7%. Take out Apple's (AAPL) blowout quarter, Barclays Capital notes, and the earnings growth rate for the S&P 500 stocks falls to 2.9%.

Add in estimates from S&P companies that haven't reported yet and the growth rate climbs to 9.2%, according to Thomson Reuters. The percentage of companies beating Wall Street earnings projections is just 64%, well below the historical average of 70% positive surprises for a quarter.

The earnings picture could weaken as we go further into 2012.

The culprit seems to be declining margins. I don't think there's anything surprising here. The global and US economies are growing just fast enough to put pressure on supply and nudge prices for raw materials higher.

But growth is just slow enough to make it hard to pass all the raw materials increases on to customers. I've seen exactly that comment in conference calls for companies as different as McDonald's (MCD) and DuPont (DD).

A margin problem of this sort comes to an end either when growth picks up enough so that companies can pass on increases in raw-materials costs or growth declines enough to take pressure off supply.

We are, however, near the end of earnings season for another quarter, and Wall Street and investors tend to pay less attention to earnings at this time in the quarterly cycle.

In other words, the earnings picture might not look good and might be setting up the market for a disappointment, but Wall Street managers and investors might be willing to overlook earnings data right now.

Do You Believe in Magic?
That's especially true, because everyone seems focused on central banks and the wonderful magic they produce by waving their magic wands at money supply.

I can't remember a moment when all the world's central banks were so busy expanding money supply-absent a clear-cut global crisis such as the Lehman bankruptcy.

And there's no immediate sign that the money supply party is about to end. As long as central banks keep pumping money into the financial markets and real economies-and as long as investors keep their faith in the magical powers of central banks-markets are likely to keep rising.

What could go wrong?

Two things, I think. First, one of the central banks could raise fears that it wasn't about to come through.

The bank I'd watch here is the People's Bank of China. I believe that the 4.5% increase in inflation, a big spike from December's 4.1% rate, is a result of the move of the Lunar New Year holiday from February in 2011 to January this year.

The Lunar New Year holiday always plays havoc with year-to-year comparisons because consumers and businesses shift so much spending around in the weeks before the holiday. But I could be wrong.

If February inflation is also up at 4.5% (or, horrors, even higher), that would raise fears that the Bank of China isn't going to keep cutting the reserve ratio and isn't going to cut interest rates in June or July. That could send China's stocks (and quite probably those of Brazil and other China-dependent exporters) into a correction.

Second, events could rattle the market's faith in the magical powers of central banks. Remember, not so long ago, investors had reservations about the effectiveness of monetary policy (pushing on a string) and the impossibility of intervening in Spain and Italy because they are so big.

Now, however, with the US economy apparently accelerating and Spanish and Italian bond yields falling, central banks can do no wrong.

What could shake that conviction? Dare I say Greece? Not this month, and not in March. This go-round looks likely to end with another agreement and another payment to prevent a Greek default on March 20.

We don't know yet what the schedule for future payments under any Greek rescue agreement will be. But if this agreement follows the form of previous agreements, the money will be parceled out in three-month stages.

After March comes June. That's enough time for the Greek economy to contract even faster than expected-which would blow a hole in this most recent agreement big enough to lead the troika of the International Monetary Fund, the ECB, and the European Union to refuse to pay out more cash unless Greece cuts its budget again.

By that time, Greece will have a newly elected government headed, in all probability, by Antonis Samaras, who was making noises about renegotiating the deal before it was signed and before he was elected. Looks like a replay of the current Greek crisis, with every player even closer to just walking away.

And by that time, it's quite possible that the recessions in Portugal, Spain and Italy will have thrown doubt on the assertion from German Chancellor Angela Merkel that Greece is a unique problem. If the ECB can't stop the run on Italian and Spanish bonds that would ensue, then investors will start doubting central banks again.

NEXT: Adding It All Up


Adding It All Up
The market is currently overbought. The US market isn't cheap on trailing fundamentals.

The rallies in China, Brazil and other developing markets depend on investors' faith in central bank money flows. The risks don't yet outweigh the potential rewards-but we're getting there.

The problem is that overbought markets can stay overbought for quite a while. And momentum of the kind that is carrying this rally can continue for quite a while. As much as I'd hate to get hit by a correction, I'd hate just as much to miss more of this rally.

When I last looked at an indicator called advisors sentiment from Investors Intelligence, the reading wasn't yet in the danger zone. It has continued to climb since then, with the percentage of bullish advisors climbing to 54.8% for the week ended on February 15, from 52.1% for the week earlier. That's getting close to the 57.3% peak in bullish sentiment in this indicator in April 2011, as stocks peaked.

The percentage of bearish advisors fell to 25.8% from 28.7%. That puts the difference between bulls and bears at 29 percentage points, the widest spread in nine months.

So what am I doing? I still think the big ECB offer of three-year money to European banks keeps the risk/reward ratio on the side of reward through February 29. European banks are likely to draw down enough money from the central bank to fulfill their borrowing needs well into 2013, and that's likely to be extremely reassuring to investors.

Add that to any positive effect from a Greek debt "solution," and I think we've got fuel for a continued rally into early March.

But in March, I'd start to look to lower the risk in my portfolio. Gradually. In US markets, I'd do that by raising some cash, substituting lower beta (less risky) stocks for higher beta (more risky) stocks and looking to dividend stocks.

(Beta is a measure of how risky a stock is in relation to the market as a whole. The market has a beta of 1. A stock with a beta of 2 is twice as volatile as the market as a whole.)

In China and Brazil and other emerging markets, I'd gradually pare bets that are pegged to optimism about central bank policy, and I'd look to emphasize domestic growth versus export growth.

I'm not recommending huge changes, because I don't think we're looking at a horrible plunge in the market. I think we're seeing a shift in risk/reward that might lead to a correction. (A reasonable estimate for a correction would be a pullback to 1,250 or 1,260-roughly 100 points from the S&P's February 17 close.)

I still think the second half of 2012 will be good to investors in stocks, so I'm not recommending that you uproot your entire portfolio. In fact, an 8% or so correction would be healthy for the market and would set up the second half of the year. But I would like to see you reduce the risk in your portfolio and raise some cash because I think we'll get a correction and a buying opportunity this spring.

If you aren't comfortable with that kind of top-down call, do this instead: On a stock-by-stock basis in your portfolio, look for instances where companies are reporting falling margins because of rising costs that they can't pass on to customers.

Look for growth cycles that may be reaching a peak. Make sure that the growth that you're counting on to power a stock isn't fading.

In the coming weeks I'll try to give you some stocks that you can use to lower the risk in your portfolio and point out some stocks where the risk is rising and the reward is getting questionable.

As always, I suggest that you use this column as a challenge to your own thinking. I'd be quite happy if you wind up disagreeing with everything I've written here if the process has made you test your own assumptions about where we go from here.

And please remember that what I've given you is a relatively short-term take on the market. The big problems of rising US debt, overextended central bank balance sheets, a falling dollar and rising US interest rates haven't gone away.

I just think that they're problems for further down the road-like 2013.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Polypore International as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund's portfolio here.