Tuesday, December 26, 2006

A Holiday Hangover for Stocks?

News Analysis
December 26, 2006

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A Holiday Hangover for Stocks?

Wall Street may have enjoyed its "Santa Claus rally" early this year, according to analysts, and major indexes could struggle at the start of 2007

Santa Claus may have already made his Wall Street visit for the year. Major stock indexes have risen solidly since a short-lived summer pullback, supported by expectations the Federal Reserve will be able to curb inflation without plunging the economy into recession. With only a week to go until 2007, however, some analysts say the market could enter the New Year limping.

Investors have certainly seen the generous side of old St. Nick this year. If market players typically look for a so-called Santa rally in the last two months of the year, then in 2006 the merriment began well ahead of schedule (see BusinessWeek.com, 11/10/06, "Stealing from Santa?"). As of afternoon trading on Dec. 22, the Standard & Poor's 500 index has advanced 15.5% since June 13, while the Nasdaq Composite has climbed 19.1% from its July 21 bottom.

Recently, though, stocks seem to have lost their holiday spirit. The S&P 500 is up a modest 0.9% so far in December, while the Nasdaq is down 1%. Generally, trading is light in the days between Christmas and New Year's. Still, a variety of technical and fundamental factors suggest stocks may continue to drift—or even pull back modestly—in the next couple of weeks, some analysts say.

No Comfort to Bulls

For one thing, sentiment indicators are at unusually optimistic levels, suggesting investors may be getting overly sanguine about the market. The weekly Investors Intelligence survey shows 59.6% bullish sentiment for the week ended Dec. 19. A week earlier, bullishness was at 59.8%, its highest reading of the year.

Meanwhile, the market has shifted its pattern. "Instead of the activity we've seen over the last couple of months, where you see pullbacks and then sharp rallies, we're now seeing a consolidation," says Chris Johnson, CEO and chief investment strategist of Johnson Research Group. "That tells us there are fewer buyers on the sidelines who are ready to jump in when things go on sale."

Nor have economic reports given any additional comfort to bulls, though they haven't bolstered the bears' case, either. Recent data on economic growth, manufacturing, inflation, and the housing sector have been mixed and consistent with forecasts of a "soft landing" for the U.S. economy, analysts say. With a so-called Goldilocks economy already priced in, these numbers haven't been enough to give the market a boost, Johnson observes.

Mutual Fund Window Dressing

Technical indicators may signal other challenges ahead (see BusinessWeek.com, 12/11/06, "Have Stocks Hit the Ceiling?"). The Dow Jones transportation average has fallen 10.4% since hitting an all-time high May 10, while the Dow Jones industrial average has gained 6.2% over the same period. Adherents of the Dow Theory believe a divergence in these two indexes means the market could be reaching a turning point.

In fact, the Nasdaq recently snapped its upward-trending ways. The tech-heavy index is down 1.3% so far in December, despite solid earnings Dec. 21 from Research In Motion (RIMM) (see BusinessWeek.com, 12/22/06, "Research In Motion's Record Year"). "If you're a trend follower, that's a pretty nasty warning sign," says Barry Ritholtz, chief market strategist at Ritholtz Research & Analytics.

As the markets wander, mutual fund window dressing will likely be the order of the day to close out the year, other analysts say. "That means you will see portfolio managers try to play catch-up," says Quincy Krosby, chief investment strategist at the Hartford (HIG). "You will see the winners, so to speak, of the quarter gain some more, and the losers will lose some more," says Krosby.

Others say the market's strong year means window dressing could play less of a factor. "You're not going to sell something the last week of the year and pay taxes on it in two days," says Art Hogan, chief market strategist at Jefferies & Co. (JEF). "You're going to sell it in January if you have the inclination to sell something."

Early Results

Complicating matters further, oil prices have rebounded in recent months. Crude futures climbed to a three-month high Dec. 20 as OPEC output cuts began to have an effect on supplies. Nevertheless, oil prices retreated over the next two sessions to end the week hovering above $62 a barrel, still down significantly from an all-time high of $78.40 reached July 14.

At the same time, results have begun to trickle out for the fourth quarter. As of Dec. 19, S&P estimates the average S&P 500 company will report earnings growth of 9%, snapping a streak of 18 consecutive quarters with double-digit percentage increases. Goldman Sachs (GS primary=), Bear Stearns (BSC), Rite Aid (RAD), and General Mills (GIS) have been among companies posting upside surprises so far, whereas FedEx (FDX) and Bed Bath & Beyond (BBBY) were among companies missing analyst expectations.

In the intermediate term, some analysts expect the market to resume its winning ways after its end-of-year lull, while others warn of a slowing economy. "These pullbacks tend to bring in a lot of pessimism, which ultimately provides more fuel for a rally as that pessimism is unwound and expectations are lowered," says Todd Salamone, senior vice-president of research at Schaeffer's Investment Research. "The lower the expectations, the stronger the possibility of an upside surprise." In the meantime, though, investors might not want to count on a Christmas miracle.

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