At the start of this year, many economists predicted that an economic crisis in Europe would grow larger, and Washington would be unable to develop a bipartisan consensus around a fix for our persistent budget deficits.

They were right on both counts.

Economists also expected corporate profits would stay strong and suggested a bit more upside for stocks as the year unfolded.

#-ad_banner-#Right again.

The S&P 500 Index rose roughly 10% in the first four months of the year. By that time, the S&P 500 had doubled from its March 2009 low. Yet the market has largely been on a downward slope since the late April peak, and we’ll likely finish the year in the red unless we get a Santa Claus rally.

What might deter such a rally? Well, we’re starting to see some year-end profit warnings from a handful of companies in the S&P 500. Chemicals giant DuPont (NYSE: DD) slashed forth-quarter guidance and now expects to earn around $0.33 a share, a 25% reduction from prior guidance. Chip makers Altera (Nasdaq: ALTR), Texas Instruments (NYSE: TXN) and Intel (Nasdaq: INTC) have all reduced guidance as well, and if other companies decide to cut their outlooks in coming days, then it will be hard for stocks to move higher by year’s end.

But what about 2012?

Well, the headline that was in place at the start of 2011 doesn’t need to be rewritten. Europe and Washington will still struggle with major fiscal problems, and corporations will still be minting cash. They key difference you should keep in mind: the market now sports a slightly lower multiple than back in January, as profits have risen even higher and the major indexes are a bit lower. In fact, the S&P 500 is now trading at decade lows on a price-to-earnings (P/E) basis — with the exception of that late 2008/early 2009 implosion.

Market strategists predict aggregated profit for all companies in the S&P 500 will rise from an expected $98 a share in 2011 to $108 a share in 2012, and rise by a similar 10% to $119 by 2013.

 
This means the S&P 500 trades at around 11.4 times projected 2012 profits. Stocks, on average, have traded for 15.9 times forward earnings during the past 30 years. The fact that interest rates are extremely low argues for an even higher multiple. So if the economy can get past the current rocky phase and start to grow at a steadier and more moderate pace, then look for many market strategists to cite that low P/E ratio as a case for market upside.

Is such a benign economic view justified? Well, recent data points imply the U.S. economy may be on the mend. The economy expanded just 0.4% in the first quarter of 2011, another 1.3% in the second quarter, 2.0% in the third quarter, and consensus forecasts call for 3.0% year-over-growth in the fourth quarter. A few Wall Street firms are even predicting a forth-quarter growth rate above 3.5%. With the exception of a big snapback in the first quarter of 2010, this would be the strongest quarterly showing in nearly five years. Still, don’t expect this kind of growth throughout 2012. There are just too many headwinds in place. Nevertheless, anything above 2% would be very welcomed by investors.

To keep growing at a 2% or 3% clip in 2012 will require that Europe and China don’t slump badly. Europe is already experiencing a modest recession, and fingers are crossed that things don’t spiral lower from here. So there is a case for cautious optimism for the U.S. economy — and stocks — in 2012.

Equally important, remember that “investors look ahead.” So even as we’ll see real challenges in 2012, the market may actually trade off of 2013 expectations. Goldman Sachs expects the world economy to expand 4.1% in 2013, a full percentage point higher than projected 2012 growth.

Of course, sector selection will be paramount. The S&P 500 may post gains in 2012, but some sectors will lag while others really thrive.

Let’s look at the technology sector as an example. It may be unwise to own a fund focused on the whole sector, as the outlook for subsectors varies. For example, consumer-focused tech stocks, especially those tied to PCs, may see another tough year in 2012. In contrast, companies in the chip-equipment sector have badly lagged in recent years and may be on the cusp of the next spending cycle upgrade. Names that hold appeal include Applied Materials (Nasdaq: AMAT) and GT Advanced Technologies (Nasdaq: GTAT), both of which trade for less than eight times projected earnings.

The outlook for many other sectors depends on the pace of employment gains and changes to the Federal Reserve’s interest rate stance. If the economy really gains a head of steam, then consumer discretionary stocks such as Disney (NYSE: DIS), automakers such as Ford (NYSE: F) and GM (NYSE: GM), and a wide range of retailers are bound to benefit. The fact that retailers such as Kohl’s (NYSE: KSS) and Macy’s (NYSE: M) trade for around 10 times projected fiscal (January) 2013 profits could start to attract bargain hunters. Best Buy (NYSE: BBY), trading at just 7.5 times projected (February) 2013 earnings, may be the best value among large retailers.

Is that backdrop likely? Well, a look back to 10 years ago may be constructive.

In 2001 and 2003, the U.S. economy shed a combined 2.4 million jobs. By 2003, investors were still fretting about a “jobless recovery.” You hear that same refrain today, but if history is any guide, then employment trends may finally perk up in 2012. So if the U.S. economy creates 2 million new jobs in 2012, then you should expect a solid market rally.

 
Of course, every silver lining has a touch of grey (as noted by the Grateful Dead), and an improving economy would likely lead investors to start thinking about interest rate hikes. Rates are so low that even a moderate boost in rates would still be quite benign in terms of the broader stock market. But rate-sensitive stocks such as utilities, telecom-service providers and other yield plays would look comparatively less appealing once government bonds start to offer more respectable payouts.

The outlook for industrial stocks would be decidedly mixed. An improving U.S. economy surely helps, but prolonged economic weakness in Europe and Japan, coupled with a possible slowdown in China would likely crimp export demand. Goldman Sachs expects sales growth for U.S. industrials to slow from a projected 10% in 2011 to just 6% in 2012. Still, many industrial stocks such as Ingersoll-Rand (NYSE: IR) and Caterpillar (NYSE: CAT) appear fairly inexpensive at around 10 times projected 2012 profits.
 
Risks to Consider: It may be a bit too soon to predict a healthy U.S. economy for 2012. A resolution to the European crisis would surely help, not only to stave off a deep recession in that part of the world, but to remove the psychological overhang for U.S. stocks.

Action to Take–> In coming weeks, you’ll hear about many bold predictions for 2012. Try to ignore those that are overly bullish or bearish. The countervailing forces affecting the U.S. economy suggest that it will simply be an OK year, and the broader market may only post modest gains. That would create the backdrop for a “stock picker’s market,” so finding the right ideas is more crucial than ever.