Go long on the economy, and hedge on stocks

February 11, 2013, 3:00 PM UTC

FORTUNE — Pity the poor economic forecaster. Following the resolution of the fiscal-cliff crisis and the Republicans’ decision not to push the U.S. government to the brink of default, at least for now, things appeared to be looking up. Retail sales and factory orders were decent, job growth was steady, and the political fog appeared to be clearing, at least partly. At Davos a few weeks back, some CEOs were talking about the economy finally taking off into a self-sustaining recovery. Then came the shocking news that GDP growth turned (slightly) negative in the fourth quarter of 2012.

Now what? Most forecasters reckon that this year will ultimately turn out pretty much like last year, when GDP rose by just 2.2%. I’m a bit more optimistic. I think the October-December mini-slump was an aberration largely caused by Hurricane Sandy and the biggest drop in military spending in 40 years. Indeed, my advice for the rest of 2013 is this: Go long on the economy and hedge the stock market. With Ben Bernanke pouring tens of billions of dollars a month into the financial system, interest rates hovering at record lows, housing recovering, and the international outlook improving a bit, don’t be surprised if GDP and job growth turn out better than anticipated. But whatever happens to the economy, don’t assume that the Dow will continue to sail serenely skyward. Investors are getting overconfident, which is often a sign of trouble ahead.

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In the past 16 months, the S&P 500 (SPX) has tacked on about 400 points and risen by more than 35%. Since March 2009, when the market hit its low, the index has been up about 120%. Without trying to resolve the theological question of whether this is a new bull market or a big rally in a secular bear market, we can be sure of one thing: Stock prices have already discounted a lot of good news. Between November and January, barring one week in December, they basically went straight up. A trader friend of mine who buys and sells stock market volatility had little or nothing to do.

We are now in the strange situation where a string of good economic news or a string of bad economic news could set off a correction. If growth exceeds expectations, investors will fret about the Fed withdrawing its stimulus, bond yields will back up, and stocks will look less attractive. By some measures, they are already stretched. According to Yale economist Robert Shiller, who looks at 10-year earnings rather than one-year earnings to smooth out cyclical fluctuations, the historical average for the market price/earnings ratio is 17.5, and the current figure is 22.8. Over time, prices usually revert to the mean. If economic growth falters, corporate profits will certainly suffer. Even now they are growing much more slowly than they were. Between the end of 2009 and the end of 2011, S&P 500 earnings jumped from $57 to $96, underpinning the big market rebound. Last year earnings rose by just two bucks, to $98, according to S&P. Yet many Wall Street analysts are predicting that this year they will somehow come in at $110 or more, which is wishful thinking.

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The most likely source of a negative shock is Washington. If the two sides fail to reach an agreement on spending by March 1, the economy will be hit with some $50 billion in automatic cuts. According to the consulting firm Macroeconomic Advisers, this alone would reduce GDP growth by about 0.7%. Combined with the tax hike that was part of the fiscal-cliff deal, its consequences would be even more serious. I’m assuming the politicians will follow their usual practice and kick the can down the road, agreeing on cuts but suspending the implementation of most of them. But who really knows? With small investors and trend followers still buying stocks, the weight of money may keep the market buoyant for a while longer. This is a good time to take profits and hedge your positions.

This story is from the February 25, 2013 issue of Fortune.