Investing for the recovery: What are the best picks?

— -- The investment climate in the next 12 months will be better than it has been since the start of the credit crisis last year. Of course, that's a bit like saying the dishes won't rattle as much now that the earthquake is over.

One year ago, the credit markets were nearly collapsing, the stock market was plunging and government officials fretted about the next Great Depression.

Fortunately, the banking system didn't collapse, and we don't live in a world of bread lines. The Standard & Poor's 500-stock index has soared 54% from its March 9 low ; interest rates have fallen; and the money markets have thawed. "All the predictions were too dire," says Robert Doll, chief investment officer at BlackRock. "The world wasn't going to end as we know it."

But few observers are jumping up and down about the prospects for the next 12 months. Even though inflation will remain low, interest rates are likely to rise, and so are taxes. The value of the U.S. dollar will probably fall on the international currency exchanges. And commercial real estate could crumble.

In short: A bull market that brings us to all-time highs seems as improbable as, well, the next Great Depression. The odds seem stacked for a middling stock market and bond market. But don't rule anything out: "The spread of possible outcomes is wider than normal," Doll says. For investors, that means it's a good time to diversify broadly — not just in stocks and bonds, but in money funds, real estate and possibly even commodities.

Because the bond market is the most sensitive to the economy, we'll start there. After all, it was the bond market that sent stocks and the rest of the financial markets reeling last year.

The next 12 months should be good for bonds, because the bond market is happiest when the economic outlook is tepid-to-grim.

To most observers, the economic outlook is tepid. Bill Gross, chief investment officer at bond powerhouse Pimco, thinks that economic growth should flatten in 2010 as the effects of the government stimulus fade. "We sense a move back to zero growth unless the employment situation gets better," Gross says.

And the employment situation isn't very good. The unemployment rate, now 9.5%, should peak at 10.3% by March, says John Lonski, chief economics for Moody's Investors Services. Unemployment is a lagging indicator — companies don't start hiring again until the recovery is well underway — but he doesn't see the jobless rate falling quickly. "It won't be a V-shaped recovery," Lonski says.

Moody's says that the default rate among companies that issue high-yield, high-risk bonds will peak in November at a postwar high of 12.7%. The all-time high, set in the Depression, was 15.4%, Lonski says.

All of which spells a good environment for bonds — with two big caveats:

•Higher yields. Bond prices fall when interest rates rise. And a big supply of Treasury bonds, combined with fewer buyers, could spell higher rates, says Gross. The Chinese, who are among the largest buyers of Treasury securities, are buying fewer Treasuries. And the Federal Reserve's program of buying Treasuries will end soon, too. "Almost by definition, yields will be higher," Gross says. "Two significant buyers of Treasuries will be disappearing."

•High prices. The bond market has already had a huge rally: The high-yield bond market has soared 50% since March. Junk bonds yield about 8% more than comparable Treasury securities. "Does that compensate for a 12% default rate? Maybe, but just barely," Gross says.

Average investors should look for high-quality bonds that mature in two to five years, Gross says. And, he says, Treasury securities really aren't such a bad deal — especially considering that the consumer price index, which measures inflation, has actually fallen 2.1% the past 12 months.

A slow-growing economy doesn't seem like the best environment for stocks, but it's not the worst, either.

"When the market got blasted last year, it was discounting the recession," says Phil Foreman, manager of the Principal Capital Appreciation Fund. The market's recent jump has forecast the end of the recession — but just what the recovery will look like is still up in the air, Foreman says. "If we have slow growth and low inflation, the stock market can do all right," he says.

Foreman, whose fund has outperformed 97% of its peers the past decade, says the government's stimulus package is starting to take hold. "The government is spending a lot of money in certain areas, and a lot of it hasn't been spent yet," he says. But in the second half of this year and the first quarter of next, some industries should start feeling the effects of the stimulus.

Which ones? The stimulus aims to rebuild the USA's infrastructure and reduce energy consumption — so companies that would benefit from mass-transit projects would be likely beneficiaries, Foreman says. Another industry that would profit from the stimulus: financial services. "People are saving more, and that's a theme that will continue," Foreman says.

The big question: Will the stock market rally take the S&P 500, which has bounced between 677 and 1565 for a decade, to new heights? BlackRock's Doll doesn't think so. "I don't think I see 1550 (on the S&P 500) before another intervening bear market and recession," Doll says. Eventually, he says, the Federal Reserve will have to raise interest rates. And taxes will probably rise, too, because of the growing federal debt. Rising rates and higher taxes rarely fuel a bull market in stocks. "I'm guessing we'll see 1250 on the S&P 500 before this move is over," Doll says.

Nevertheless, Doll thinks there will be some industries that fare better than others. He likes energy, which will do well if the economy starts growing, and health care as a defensive play. For those looking for growth, technology stocks should fare well even in a lackluster economic environment.

Real estate has long been used as a diversification play: After all, commercial real estate doesn't march in lockstep with either stocks or bonds. For most investors, the best way to diversify into commercial real estate is through real estate investment trusts, or REITs. These companies invest in office buildings, apartments, shopping malls and other commercial properties and pass nearly all of their income on to investors through dividends.

If you're thinking of diversifying into real estate, however, you have some time to think about it: The outlook for the next 12 months or so is unrelentingly grim.

"We think we'll be moving along the bottom in 2010, or that some additional stress to be realized will show itself," says Ed Casas, senior managing director of Navigant Capital Advisors. Why real estate remains distressed:

• Commercial real estate delinquency rates are at levels not seen since 1994, and rising. Values have fallen 49% in San Francisco, 43% in Phoenix and 44% in New York City.

• Lenders aren't lending. Because delinquency rates are rising, loans are exceptionally hard to find. Casas' assessment of the real estate loan market: "It's moribund."

• Unemployment remains high and consumer confidence is low — both of which mean that demand for new office buildings and malls will stay low.

Commodities — gold, corn, pork bellies — have long been promoted as a good diversification play for investors. After all, rising princes are inflationary, and stocks and bonds loathe inflation. And investors can now choose among dozens of exchange-traded funds that track the prices of everything from steel to water.

Unfortunately for those investors, inflation is dead. Commodity prices have fallen about 30% the past 12 months, because demand has fallen — and not just here, but in China and India as well.

Even if the economy breaks out of its slumber tomorrow, you have plenty of time to add commodities to your portfolio. Demand for raw materials heats up after companies have sold off their inventories and factories are working at capacity. Currently, factory capacity utilization in the U.S. is at 68.5%, vs. its long-term average of 80.9%. Mines are running at 81.7% of capacity, vs. 87.6% from 1972-2008.

If you decide to add commodities to your portfolio, stick with funds that track a broadly diversified commodity index, rather than a single commodity. You'll get greater diversification and less volatility.

If you're concerned about the falling value of the dollar, you might also consider adding gold to your portfolio. Gold prices tend to rise when investors lose faith in printed money. But be careful: Gold is hovering near its all-time high. Most experts say you should keep no more than 5% of your portfolio in gold, and that you should rebalance your holdings periodically to make sure it doesn't become too large a part of your portfolio.

What about money market securities, or cash? Right now, keeping cash on the sidelines will cost you, too. The average money market fund yields 0.06%, or 6 cents for every $100 you invest.

The good news is that the money market has stabilized: The short-term IOUs that money funds buy and sell are the lifeblood of the financial system. Had Bear Stearns or Lehman Bros. been able to get short-term loans in the money market, they might well be around today.

The modest government insurance on money funds, covering all assets held before Sept. 18 last year, ends Friday.

And short-term rates are unlikely to rise until late in 2010, Moody's Lonski says. "The Fed won't raise rates until August 2010 at the earliest, and if it does, the fed funds rate won't be any higher than 1% in 2010," he says.

Savers can earn a bit more money by moving to short-term bank CDs or money market accounts. But if you want to play it safe in this environment, you'll need to accept lower yields.

Despite all the gloom, investors have reason to be optimistic in late 2010 and beyond. As corporations and individuals pay down their debts, they will have more money to spend — and that translates into a more robust economy.

Corporations that repay debt now, for example, will have more cash on hand later to grow and expand. And even if the Fed does push rates higher, a 1% fed funds rate is exceptionally low by historical standards.

"We are in a recovery, the recession does seem to be ending, and there's a ton of cash on the sidelines getting a zero percent return," says BlackRock's Doll.

The stock market is no longer fretting about whether corporations will survive, but whether they will grow. And that, at least, is usually a good sign for the investment climate.