Despite the stock market’s ongoing rally, our outlook for the US economy remains unchanged. We continue to expect US gross domestic product (GDP) to grow at a subpar rate as the economy recovers from the excesses of the credit bubble and financial crisis. US economic growth will likely average 2 percent to 3 percent annually, as opposed to the 3 percent to 4 percent to which many investors have become accustomed.

Muted GDP growth makes the economy more vulnerable to shocks than in the past. The spike in oil prices in the first half of 2011, coupled with manufacturing supply-chain disruptions after the earthquake in Japan, probably shaved between 0.5 and 1 percent from US economic growth. If the economy were growing at a rate of more than 3.5 percent, investors wouldn’t have batted an eye over this temporary slowdown.

But with the US economy limping along, even a modest temporary headwind can depress economic data. Many investors misdiagnosed last summer’s economic soft patch as the beginning of a major downturn. Throughout this period of malaise, we maintained (correctly) that the US wouldn’t slip into recession and that the EU sovereign-debt crisis wouldn’t erupt into a 2008-style credit crunch.

The converse is true early this year: Many investors appear to be mistaking the dissipation of last year’s headwinds for accelerating growth. With the market having regained its exuberant outlook, we remain less sanguine about equities and economy. That’s not to suggest that we expect the US to enter recession in 2012; rather, the ongoing rally in the stock market reflects increasing optimism about economic growth at a time when risks are increasing.

Key economic data points have improved dramatically. The four-week moving average of initial jobless claims, for example, has dropped to about 350,000 filings, compared to an average of more than 400,000 applications for most of 2011 and almost 450,000 in the first part of 2010. This trend suggests that the employment market continues to heal, a development that should support consumer confidence and spending.

Source: Bloomberg

The decline in initial jobless claims doesn’t invalidate our long-standing argument that the US economy faces a period of lackluster growth. Despite the recent improvement, consumers have little capacity to boost spending dramatically: Wage earners are treading water when income growth is adjusted for inflation. In January 2012, for example, US personal disposable income grew only 0.1 percent sequentially.

Rising oil and gasoline prices likewise threaten to inhibit economic  expansion. In early 2011, energy prices surged after civil war disrupted Libya’s oil exports, a shock that weighed on the US economy in subsequent months. Oil and gasoline prices have climbed once again in 2012.

Source: Bloomberg

A barrel of Brent crude oil continues to fetch a roughly $20 premium to the equivalent volume of West Texas Intermediate (WTI), the US benchmark. This divergence stems primarily from logistical constraints that have resulted in a localized oversupply of crude oil at terminals in Cushing, Okla., the delivery point for the oil futures that trade on the New York Mercantile Exchange. Refiners in the Mid-Continent region benefit from this pricing anomaly, purchasing WTI at a discount and selling refined products at prices that track the price of Brent crude oil.

But higher gasoline prices will take their toll on US consumers’ driving and spending habits.  

Source: Bloomberg

This graph tracks the year-over-year change in the total miles driven by US consumers. As you can see, elevated oil and gasoline prices prompted drivers to cut back on the miles they logged on the road. Conservation aside, higher prices at the pump mean that households have less to spend on discretionary items.

Finally, the Citigroup US Economic Surprise Index, which tracks how economic data points compare to analysts’ consensus estimates, indicates that the frequency of upside surprises has begun to wane after six months of reports that trumped expectations.

When the index rises, economic data have consistently surpassed expectations; a decline in the index indicates that data have consistently fallen short of estimates. Citigroup (NYSE: C) calculates this index on a rolling three-month basis; the current reading reflects economic data from early December onward.

Source: Bloomberg

The Citigroup US Economic Surprise Index remains in positive territory but has pulled back from its recent high after key indicators such as the Purchasing Managers Index for manufacturers came in below the consensus estimate in February. These shortfalls reflect analysts’ overly optimistic outlooks and some deterioration in economic conditions. (See “Curb Your Enthusiasm.”)

Investors should also remember that the EU sovereign-debt crisis will continue to roil markets. Although the European Central Bank’s three-year loan at cut rates have bolstered capital levels at EU financial institutions , the Continent’s credit issues have yet to be resolved. The fiscally weak Club Med nations still face years of painful fiscal austerity to bring their governments’ debt burdens under control. With near-term pressure in the credit market abating, the motivation to enact unpopular reforms likewise declines.

Most recently, the Spain’s government has pushed back against additional austerity demanded by EU policymakers. A weak domestic economy could also prompt Italy to resist making the necessary budgetary cuts.

Meanwhile, the US faces a presidential election in November, as well as the expiration of the tax cuts implemented by George W. Bush and a series of mandatory spending cuts in early 2013. If these scheduled tax hikes and spending cuts go into effect, the result would be the largest fiscal contraction in the US since World War II–hardly welcome news for an economy that’s growing at a lackluster pace.

That’s not to suggest that a US recession is imminent or that the stock market will collapse. However, investors have grown overly optimistic in their outlook for the US economy, which could lead to a 5 percent to 10 percent correction in the stock market.

Caveat Emptor

In the previous issue of The Energy Strategist, Sticking to Our Values, we cautioned that some of the higher-yielding master limited partnerships (MLP) and oil and gas trusts looked overbought. In the subsequent weeks, several of these names have pulled back sharply, likely because of profit-taking.

With the S&P 500 up significantly in the new year and economic risks rising, you shouldn’t chase any Portfolio holdings above our buy targets. Investors sitting on substantial gains in these stocks should consider sellingone-quarter to one-half of their position. This move will turn paper gains into real profits and give you some dry powder to deploy in the event of a correction.