By Paul B. Farrell, MarketWatch

Last Update: 7:24 PM ET Jan 8, 2007

ARROYO GRANDE, Calif. (MarketWatch) -- OK folks, had a bit too much New Year's hype from the bulls? Me too! Feel like maybe Wall Street's still sipping Dom Perignon, celebrating their megabonuses, while slipping you their latest concoction of Kool-Aid? I'm with you!

So let's back up and restart 2007 by etching on our brains four simple rules from the new science of behavioral finance, better known as 'irrational investing:'

1. Optimism kills investment returns
2. If anything can go wrong, it will
3. Protect your assets; never lose money, never
4. When in doubt, go contrarian and win

They'll fit on just one little Post-it. The miniversion: "Optimism kills; Murphy's Law; Never lose money; Contrarians win." Four simple rules: Put it near your monitor, as a reminder of your retirement risks next time you want to throw money at some hot stock hyped this year.

Why the warning? It's from a highly respected and audacious contrarian, economist Gary Shilling, author of a couple books on deflation and a Forbes columnist. He's not buying the bullish hoopla about the so-called 2007 stock market rally. Quite the contrary. You've seen the hoopla all over the press. For example: one day USA Today details "10 Reasons Why the S&P 500 Could Hit a Record High." Next day in their survey of economists, not one bear in the herd, it's a total bullish consensus.

Folks, there are too many bulls and too few bears among America's economists. Brave bulls? More like sheep, playing it safe, herding together around long-term averages. Their loyalty is to the big companies and banks who sign their paychecks. They have to be bullish. Reality scares customers away. And yet, any respectable contrarian will tell you that too many bulls is always a bearish signal. And we sure had a ton of bulls ringing in the New Year.

But still, reading Shilling's January 2007 Insight Newsletter was a scary experience, totally opposite what the rest are saying. Here's a staccato overview: Housing bubble still deflating ... economy slipping into recession ... hard landing in China ... recession spreads worldwide. Then something other economists would never utter out loud (until it's too late to help you and me): U.S. stock prices will collapse, perhaps below the 2002 lows. Remember when the S&P 500 dropped to 776? Yikes!

Nobody loves a smart-ass contrarian, especially not today when Wall Street's spinmeisters need to hype up American consumers and investors for a fifth year of the bull market. Shilling didn't even expect a fourth. He admits he was "premature" in predicting the widespread ripple effect following a housing price collapse, and is surprised the recession hasn't already begun.

I'm sure permabulls and naysayers will dismiss Shilling with remarks like "even a broken clock is right twice a day." Yes, timing is crucial in forecasting. But while a broken clock just sits passively and predictably through a short 24-hour period, a $12 trillion economy lumbers along with massive force slowly and unpredictably through its recession/recovery cycles, taking many years.

"The aftermath of a collapse in housing prices, ominous as it will be, could take some time to play out ... if the house price slide is more gradual, it could take months, quarters, maybe even longer for homeowners to believe their houses are worth anything less than their peak 2005 prices ... This isn't a soft landing scenario, but one that postpones consumer retrenchment and recession until late 2007 or even 2008."

So whatever you do, don't be too quick in dismissing Shilling's forecasts just because they make you anxious and your internal gyroscope prefers the roaring optimism of bulls. Listen very closely, this scenario will have a powerful effect on your retirement nest egg.

Six overriding trends

Shilling says the same six background forces that dominated last year are still driving the investment climate in 2007. Worse yet, they continue inflating our expectations bubble, making the economy and markets increasingly more vulnerable:

1. Easy money: The world's awash in liquidity, fueling speculation
2. Inflation is low and could even shift into a deflationary cycle
3. Investment returns are low, disappointing most investors
4. Rampant speculation, thanks to the Fed, Wall Street and Washington
5. Investor risks increase, hoping to achieve expected higher returns
6. Insatiable consumers will spend until borrowing power is exhausted.

OK, so that's the economic landscape surrounding you, me and the rest of America's 94 million investors in 2007. In this challenging environment Shilling eight specific scenarios that will occur this year, plus four "maybes" that may be delayed till later:

1. Housing prices will collapse: "The likelihood of house prices falling substantially to bring them into proper balance ... a 25% decline in house prices nationwide is not a wild forecast, and may be optimistic. Indeed, a 38% fall would be needed to get house prices back in line."
2. The Fed will ease and the yield curve will remain inverted
3. U.S. stock prices will fall, perhaps below 2002 lows, in the midst of a recession
4. China will suffer a hard landing, due to internal cooling and a U.S. recession
5. U.S. and China problems will spread, depressing economies and stocks
6. Treasury bonds will rally, with yields falling as low as 3%
7. The commodity price bubble will soon collapse
8. U.S. dollar will strengthen after the recession spreads worldwide

Shilling also forecasts four other trends that may not happen in 2007, but could accelerate the collapsing scenario in 2008 or later. They are: Chronic global deflation, a renewed cycle of savings as consumers shift away from 25 years of excessive spending and borrowing and a general decline in speculative ventures.

So what's missing? The biggest one: War! War isn't factored into economic equations. Economists do with their forecasts what Washington politicians do with budget deficits, hide a lot. Both ignore the future economic costs of accelerating global violence, the war on terror, the civil wars in Iraq and Afghanistan, the nuclear threats posed by Iran, North Korea and al Qaeda, our weak borders and homeland security, and other threats.

And no calculations for any new "unintended consequences" of escalating our war economy with a euphemistic 'surge' of troops. We're in denial: Another unpredictable 9/11 attack would trigger a rapid economic meltdown, nullifying all the upbeat forecasts of America's bullish economists. In short, our myopia about geopolitical realities blinds us to the biggest of all costs in the economic equation.

So, what's the best way to protect yourself in 2007, whether a rally or meltdown? Next week we'll update our five " lazy portfolios," simple well-diversified portfolios of no more than 11 no-load low-cost index funds that take advantage of the entire spectrum of stocks and bonds, without playing the "Mad Money" game.

That's your best protection, regardless of which scenario plays out; a bull, bear or contrarian scenario.

1. Optimism kills investment returns
2. If anything can go wrong, it will
3. Protect your assets; never lose money, never
4. When in doubt, go contrarian and win

Why the warning? It's from a highly respected and audacious contrarian, economist Gary Shilling, author of a couple books on deflation and a Forbes columnist. He's not buying the bullish hoopla about the so-called 2007 stock market rally. Quite the contrary. You've seen the hoopla all over the press. For example: one day USA Today details "10 Reasons Why the S&P 500 Could Hit a Record High." Next day in their survey of economists, not one bear in the herd, it's a total bullish consensus.

Folks, there are too many bulls and too few bears among America's economists. Brave bulls? More like sheep, playing it safe, herding together around long-term averages. Their loyalty is to the big companies and banks who sign their paychecks. They have to be bullish. Reality scares customers away. And yet, any respectable contrarian will tell you that too many bulls is always a bearish signal. And we sure had a ton of bulls ringing in the New Year.

But still, reading Shilling's January 2007 Insight Newsletter was a scary experience, totally opposite what the rest are saying. Here's a staccato overview: Housing bubble still deflating ... economy slipping into recession ... hard landing in China ... recession spreads worldwide. Then something other economists would never utter out loud (until it's too late to help you and me): U.S. stock prices will collapse, perhaps below the 2002 lows. Remember when the S&P 500 dropped to 776? Yikes!

Nobody loves a smart-ass contrarian, especially not today when Wall Street's spinmeisters need to hype up American consumers and investors for a fifth year of the bull market. Shilling didn't even expect a fourth. He admits he was "premature" in predicting the widespread ripple effect following a housing price collapse, and is surprised the recession hasn't already begun.

I'm sure permabulls and naysayers will dismiss Shilling with remarks like "even a broken clock is right twice a day." Yes, timing is crucial in forecasting. But while a broken clock just sits passively and predictably through a short 24-hour period, a $12 trillion economy lumbers along with massive force slowly and unpredictably through its recession/recovery cycles, taking many years.

"The aftermath of a collapse in housing prices, ominous as it will be, could take some time to play out ... if the house price slide is more gradual, it could take months, quarters, maybe even longer for homeowners to believe their houses are worth anything less than their peak 2005 prices ... This isn't a soft landing scenario, but one that postpones consumer retrenchment and recession until late 2007 or even 2008."

So whatever you do, don't be too quick in dismissing Shilling's forecasts just because they make you anxious and your internal gyroscope prefers the roaring optimism of bulls. Listen very closely, this scenario will have a powerful effect on your retirement nest egg.

Six overriding trends

Shilling says the same six background forces that dominated last year are still driving the investment climate in 2007. Worse yet, they continue inflating our expectations bubble, making the economy and markets increasingly more vulnerable:

1. Easy money: The world's awash in liquidity, fueling speculation
2. Inflation is low and could even shift into a deflationary cycle
3. Investment returns are low, disappointing most investors
4. Rampant speculation, thanks to the Fed, Wall Street and Washington
5. Investor risks increase, hoping to achieve expected higher returns
6. Insatiable consumers will spend until borrowing power is exhausted.

OK, so that's the economic landscape surrounding you, me and the rest of America's 94 million investors in 2007. In this challenging environment Shilling eight specific scenarios that will occur this year, plus four "maybes" that may be delayed till later:

1. Housing prices will collapse: "The likelihood of house prices falling substantially to bring them into proper balance ... a 25% decline in house prices nationwide is not a wild forecast, and may be optimistic. Indeed, a 38% fall would be needed to get house prices back in line."
2. The Fed will ease and the yield curve will remain inverted
3. U.S. stock prices will fall, perhaps below 2002 lows, in the midst of a recession
4. China will suffer a hard landing, due to internal cooling and a U.S. recession
5. U.S. and China problems will spread, depressing economies and stocks
6. Treasury bonds will rally, with yields falling as low as 3%
7. The commodity price bubble will soon collapse
8. U.S. dollar will strengthen after the recession spreads worldwide

Shilling also forecasts four other trends that may not happen in 2007, but could accelerate the collapsing scenario in 2008 or later. They are: Chronic global deflation, a renewed cycle of savings as consumers shift away from 25 years of excessive spending and borrowing and a general decline in speculative ventures.

So what's missing? The biggest one: War! War isn't factored into economic equations. Economists do with their forecasts what Washington politicians do with budget deficits, hide a lot. Both ignore the future economic costs of accelerating global violence, the war on terror, the civil wars in Iraq and Afghanistan, the nuclear threats posed by Iran, North Korea and al Qaeda, our weak borders and homeland security, and other threats.

And no calculations for any new "unintended consequences" of escalating our war economy with a euphemistic 'surge' of troops. We're in denial: Another unpredictable 9/11 attack would trigger a rapid economic meltdown, nullifying all the upbeat forecasts of America's bullish economists. In short, our myopia about geopolitical realities blinds us to the biggest of all costs in the economic equation.

So, what's the best way to protect yourself in 2007, whether a rally or meltdown? Next week we'll update our five " lazy portfolios," simple well-diversified portfolios of no more than 11 no-load low-cost index funds that take advantage of the entire spectrum of stocks and bonds, without playing the "Mad Money" game.

That's your best protection, regardless of which scenario plays out; a bull, bear or contrarian scenario.

Many investment pros are starting the year with high hopes, looking for a repeat of last year's double-digit stock gains.

These same optimists also cite a litany of potential problems that could stand in the market's way.

U.S. stock gains surpassed almost everyone's expectations in the past six months because the economic backdrop has been almost perfect, with cooling inflation, falling gasoline prices, a benign Federal Reserve and surprisingly strong corporate profits.

"I am optimistic for the overall market -- quite optimistic," says Susan Malley, president of Malley Associates Capital Management in New York. "What could go wrong? If we had rising interest rates, if we had oil prices back to the kinds of levels we saw over the summer, when they were above $77 a barrel, and, of course, if we had an international political disturbance."

Here is a look at the drivers the stock market depends on and the stumbling blocks it must avoid this year.

Inflation

One of the main reasons for investor optimism is that inflation has appeared to be slowly coming under control.

Last year's stock-market surge coincided with a plunge in oil futures, which fell to $56.31 a barrel last week, from $77.03 in July. Gasoline futures have dropped 40% since May, to $1.49 from $2.49.

Inflation in the rest of the economy, excluding volatile energy and food costs, has edged down more slowly toward the 2% rate Fed officials have said they consider the upper limit of what is tolerable.

Low inflation is good for stocks because it encourages consumers to spend and helps the Fed keep interest rates down. Low interest rates are another of the market's main underpinnings.

The worry among economists and money managers is that any sudden uptick in oil prices or other inflation measures would upset this balance.

"My No. 1 concern is that we get complacent now, with energy prices down because of the mild winter," says Robert Morris, chief investment officer at Jersey City, N.J., fund-management group Lord Abbett -- although he, too, counts himself among the optimists for stocks.

Interest rates

The Fed stopped raising its target short-term interest rate this summer and hopes are widespread it will begin cutting rates this year.

The Fed's campaign of rate increases, aimed at forestalling inflation, ran for two years starting at the end of June 2004. Often, when the Fed raised rates in the past, it left the economy in recession. This time, many money managers think it can prevent inflation without causing recession and that was among the main reasons for Wall Street optimism in autumn.

The expectation of Fed rate cuts this year, amid continuing economic growth, has helped push bond yields, mortgage rates and other market interest rates lower. That helped send stocks on their prolonged rally, because lower rates support most consumers and businesses and make bonds and money-market funds less attractive than stocks.

The fragility of the rate hopes was evident Friday, when stocks slumped following a Labor Department report that showed December hiring and wage increases were stronger than many expected. Economists think the Fed will hesitate to cut rates until it sees signs of a cooler labor market.

Fed Chairman Ben Bernanke has warned he is more likely to raise rates than to lower them at this point. And any serious risk the Fed might not cut rates at all this year -- or that it might actually raise them again -- would be an unpleasant pill for the stock market.

Profits

A third big driver for stocks last year was corporate profits, which again left expectations in the dust. Profits for companies in the Standard & Poor's 500-stock index rose almost 20% in the third quarter. When last year began, many money managers expected profit growth to be sagging toward the single digits by now.

Many expect to see a pullback to single-digit profit gains this year as economic growth slows, and the question is how stocks will react.

Stocks often do well when profits are rising at a cooler, more sustainable pace, because that often is a time when the Fed is lowering interest rates or holding them steady. Problems crop up when profit increases turn more anemic than investors expect.

In part because they were chastised for their excess optimism at the end of the last bull market, stock analysts have become more conservative. That has made it easier for companies to surpass analysts' forecasts.

If companies continue to surpass forecasts, even if their profit-growth slows, stocks could extend gains. But at some point in any business cycle, expectations among investors and analysts tend to get overly bullish and companies begin to miss profit forecasts.

"If you had a couple big companies come in with results that are below the forecast, that could be a shock," says Ms. Malley of Malley Associates.

Economic, political stability

Threats to world stability remain in the backs of many investors' minds. So does the risk of a housing crisis.

Investors seem to have adjusted to the violence and bombast they know -- terrorist threats, saber rattling in Iran and North Korea, fighting in the Middle East. What they fear, privately, is something more severe -- actual use of a nuclear weapon, for example, or another terrorist attack in the U.S.

The ability of countries in developing Asia, Eastern Europe and Latin America to record strong economic growth despite the uncertain world has helped allay some fears. So have falling mortgage rates, which have spurred hopes the worst of the housing slump could be over.

"Where could things go wrong? If there was some kind of [major] event, whether it be in the Middle East or some other area of international politics, or a blowup in one of the high-octane market areas such as housing or hedge funds," says Jeff Schappe, chief investment officer at BB&T Asset Management in Raleigh, N.C.

Mr. Schappe, like Mr. Morris and Ms. Malley, counts himself a market optimist, and he isn't predicting a problem.

But many investment pros recognize that the market's strength has been built on a series of very positive developments. The stock market today is a bit like a juggler, whose success depends on keeping all those shiny balls successfully in the air.