The biggest one-day rally for Australian stocks in 18 months lifted optimism towards the market late last week, but one analyst warned the rally could have been just a 'dead cat bounce'.
Australian stocks have slumped over 10 percent since mid-May, sharing in the global market gloom over a potential end to the U.S. central bank's quantitative easing program, but on Friday the index bounced over 2 percent, notching its largest one-day gain in 18 months and raising hopes that the index could be set to recoup some of its losses.
On Monday, the benchmark S&P 200 continued the winning streak after a weak open, rising 0.5 percent by mid-day to 4817.30.
But according to Evan Lucas, market strategist at IG Markets, investors should not get too excited about the rally as major headwinds could keep the index well off the highs of over 5,000 seen earlier this year.
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"In the worst case, if we don't get a rate cut [by the Reserve Bank of Australia] in July and we don't get clarity on the [Fed] tapering issue, we could see the ASX falling to around the 4,650 level by the end of the year," said Evan Lucas, market strategist at IG Markets, referring to an approximate 3.5 percent decline on current trading levels.
"If last week was a dead cat bounce, the global mood change to gloom will continue to see the ASX sliding down the Matterhorn," said Lucas.
Investors are hotly anticipating the outcome of the Federal Open Markets Committee two-day meeting which wraps up on Thursday, where Chairman Ben Bernanke at is expected to indicate the bank's next move.
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If he does hint a slowing of the bank's expansive quantitative easing program, global markets worldwide are expected to sell off as they panic over the implications of a lack of central bank support.
But conversely, if Bernanke were to provide clarity at the FOMC meeting on Thursday, it could take Australian stocks the other way and boost stocks by up to 10 percent, said Lucas.
"If Bernanke puts more issues into the matter and does not provide clarity, this will provide further jitters, but if Bernanke gives some clarity on when the tapering will start, that should provide some stability and we could see the ASX hit 5,200 to 5,300 by year-end," he added.
Rate Cut Wild Card
Lucas said the next few weeks should set the tone for Australia's stock market for the rest of the year.
Aside from watching the Fed, markets will also be focusing on the upcoming central bank decision in July, where another rate cut is broadly anticipated.
The Reserve Bank of Australia last cut rates in May to 2.75 percent, and a further cut is expected next month in an effort to boost the economy and minimize the negative impacts of the country's mining sector reaching a peak in investment.
A rate cut should act as a boost to stocks by pushing investors away from cash and fixed income and into higher yielding equities.
"A rate cut in July would help the ASX, but if we don't get one in July, this will wipe out any chance of a cut in August or September because the Federal Election on September 14," he added.
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Ric Spooner, chief market analyst at CMC Markets Asia Pacific, said last week's rally on the ASX demonstrated that the ASX was moving back to a long-term, sustainable valuation on a price-to-earnings basis.
"We are about 5 percent away from a reasonable long-term average given current interest rate levels," said Spooner, who sees 4,600 level as a fair valuation for the ASX, which was trading at around 4,792 on Monday.
The tapering of quantitative easing measures in the U.S., however remained a major headwind for Australian investors, he acknowledged.
"Regardless of what happens this week, it [tapering] is definitely now on the cards and this will be a negative for Australia," added Spooner.