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Market Outlook: Bulls Still Have Means to Run

Welcome to investors' paradise -- a sea of cash, a wave of mergers and no Fed in sight.

Analysts point to three factors driving U.S. stocks: huge amounts of cash on company balance sheets and in private equity firms; corporate appetities for gobbling up other companies, and a Federal Reserve Board that appears poised to remain on the sidelines.

This past week, the Dow Jones Industrial Average hit another all-time high, while the S&P 500 traded at its highest level since September 2000.

"I think the bias is still to the upside," Barry Ritholtz, chief market strategist at Ritholtz Research & Analytics, told CNBC.com. "There are some risk factors out there with earnings decelerating and the economy slowing, but there's nothing on the immediate horizon that says you've got until next Tuesday."

Less Fear of the Fed

Stocks rallied Wednesday and Thursday after Federal Reserve Chairman Ben Bernanke eased concerns about a near-term rate hike. Although inflation remains the primary concern, Bernanke said inflationary pressures appear to be easing.

Expectations for an interest rate cut had diminished in recent weeks as mixed economic data pointed to strength in the broader economy despite weakness in housing and auto sales. The prospect for an interest rate cut is still on the table, albeit later in the year.

"The market is building in a 50% probability of a rate cut around September and, I think, Bernanke has made it clear you won't see any change until late summer," said Paul Mendelsohn, chief investment strategist at Windham Financial Services. "They want more data to show that inflation is under control for longer than a short time."

Ned Riley, CEO of Riley Asset Management, believes the Fed will likely lower interest rates by the third quarter of this year.

"On the inflation issue, I've said all along these guys are nuts because inflation is low," Riley told CNBC. "The only thing we've got to watch out for is this January CPI number. That one could be seasonably higher, but the bottom line is that inflation's low and interest rates are going lower."

The Consumer Price Index (CPI), a key gauge on inflation, will be released Wednesday, February 21. Economists are looking for a modest 0.1% increase in consumer prices due to a decline in oil.

"Sloshing Around"

Analysts say a major driving force for the recent rally has been the massive influx of liquidity in the markets.

"There's clearly a lot of cash sloshing around and that lends itself to a lot of momentum," said Ritholtz.

"It's massive," Chuck Lieberman, chief investment officer at Advisors Capital Management, told CNBC.com. "There's tremendous cash in the hands of the LBO and private equity guys. The companies themselves are sitting on massive amounts of cash to do deals, buy back stocks and pay dividends."

This past week several companies put their cash to work with repurchasing plans. Caterpillar announced a $7.5 billion buyback, Honeywell said it would buy back $3 billion in shares and 3M unveiled a two-year plan to buy back $7 billion of shares, the largest buyback in that company's history.

M&A Fever

Analysts point to the slew of recent merger and acquisition news, real and rumored, as another factor that is driving the markets.

"Just this past week, you had news about Alcoa and Compass BancShares," Jeff Krumpelman, senior portfolio manager at Fifth Third Asset Management, told CNBC.com. "We're seeing a lot of cash on the balance sheets and we believe this merger and acquisition activity will continue."

"M&A is definitely a valid issue," said Ritholtz. "It's one of the reasons nobody is shorting stocks because you run the risk someone will buy the company."

Takeover speculation boosted shares of Dow component Alcoa after a London newspaper reported the aluminum giant could be acquired by Australia's BHP Billiton and Rio Tinto. Compass Bancshares agreed to be acquired by Spain's Banco Bilbao Vizcaya Argentaria.

While there are plenty of bonafide M&A deals to mull over, the markets are also reacting to deals that haven't been confirmed such as Friday's report that General Motors is in talks to acquire the Chrysler unit of DaimlerChrysler.

"I think M&A is going to be a catalyst, but investors have overreacted to the news out there," said Windham's Mendolsohn. "Every day we get a rumor and you see these stocks take off like the investors are trained to salivate when they hear these things. There will continue to be takeovers, but it may not be at the pace people expect."

An Old Rally with New Tricks

Many analysts believe all of these drivers point to a move up for stocks, if not near-term, then by the end of the year.

"This is one of the longest periods of time we've gone without a 10% correction, so I wouldn't be surprised to see a pullback early on here in 2007," said Fifth Third Asset's Krumpelman. "But we're positive for the year and we have a target of 1600 on the S&P 500 by the end of '07."

"It's possible this thing could keep going, but probably not at the pace that it has," said Mendelsohn. "I see more backing and filling about to take place here in the near-term."

"I believe the rally will continue," said Advisors' Lieberman. "Why should it end? Because it's getting old? The rally doesn't know it's getting old."

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