Looking ahead at prospects for the share market in 2012 provides both reasons for optimism and notes of caution. Quite clearly, the inherent economic weaknesses of most western economies are still with us, and some weaknesses from the growth stories of the developing world are also starting to cause concern. We’re still going through the “work-out” phase of the great leveraged debt binge of the pre-2008 decade. What we saw in the US with their sub-prime mortgage debacle, and the sovereign debt imbroglio in the Eurozone at present, is all part of that work-out, and of course it is not over yet.

Housing: some good news out of the US?

Perhaps surprisingly, the outlook from the US is probably better than the market expects. Positives emanating from what is still more than a fifth of the world economy include a possible US housing recovery, a turnaround in US manufacturing, and good news on exports and on the energy front.

US housing is most important, and there are some indications that a recovery could emerge after excess homes get absorbed by the middle of 2012. There are indications that excess home supply is dwindling, and that could provide a floor in home prices, mortgage losses, construction industry job pressures, and consumer confidence. After six years, the housing bubble deflation may be close to an end.

Housing: some bad news out of China?

We think it is worthwhile keeping a wary eye on the property bubble in China. That may seem rather esoteric for Australian share market investors, but a collapse in Chinese residential property prices could have a huge impact on the Australian economy.

After a decade of soaring prices, the signs are there that China is facing its first real estate crash. House prices in Beijing have risen by about 150% in the past four years. Across the country, from the big cities to the regional towns, new housing developments have sprung up in recent years as developers and local governments have rushed to capitalise on the frenzy for property. But now, following a 10 year boom and nearly two years of attempts by the central government to cool the overheated sector, the market appears to have turned down. Sales volumes have slid and prices are falling as developers try to tempt reluctant buyers with discounts.

The prospect that this sector could come to a screeching halt has serious implications, especially for commodity exporters like Australia. Last year, property construction accounted for 13% of GDP in China, and for more than 25% of all investment in an investment-dependent economy. Property directly accounts for 40% of Chinese steel use, making it by far the most important buyer of inputs such as the iron ore and metallurgical coal that Australia exports.

Steady as she goes in Australia

Back to Australia, and a grateful acknowledgement that we have been very lucky. We weren’t too caught up in the debt binge, and we enjoy strong export markets for our goods. We have relatively low unemployment, and a growing population. We have a strong currency, and neutral interest rate settings. We have a strong banking sector and a good regulator. And our housing market is reasonably stable.

We expect the market to remain quite volatile for the next year, but it is impossible to be precise with these things. Within the next year or two, we should have remedied quite a few of the “work-out” issues and at that stage would anticipate a stronger market. But “no-one rings a bell”. In order to cope with volatility, one should adopt the following strategies: retain reasonably high cash levels; stay away from excessive debt; focus on value and on quality; look for sustainably high yield; and focus on domestic Australia where we have fewer headwinds to contend with. And remember, market volatility creates opportunity: to buy high quality company shares below intrinsic value and selling above it.