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Market Outlook: Stocks Likely To Continue Defying Forecasts

Wall Street has spent much of this year defying expectations, and if it continues to do so that could set up a wild end to 2009.

Traders at the New York Stock Exchange.
Photo: Oliver Quillia for CNBC.com
Traders at the New York Stock Exchange.

Stocks have held up well in the normally rough months of September and October, with the Standard & Poor's 500 eking out a modest gain during a time period known as the toughest of the year.

But maintaining the market momentum during November and December, which historically have kicked off the market's friendliest six-month run, will be a stern challenge as some market pros wonder if the air is running out of a seven-month rally.

Volatility seems to be a principal watchword of the market, exemplified by Monday's trading in which the market surged shortly after the open on positive economic data but lost all its gains by lunchtime.

"We're going to be paying attention to the rest of earnings to see if investors are given any more reason to come into the market at these valuations," says Quincy Krosby, general market strategist at Prudential Financial. "We had a very strong liquidity-driven rally. What you're seeing now is the market is getting more selective."

The uncertainty of the market has been exemplified by the Chicago Board Options Exchange's Volatility Index , which has surged in recent days after threatening to fall below the important 20 level.

Earnings will continue to garner attention, but most of the big companies have already reported.

The market will be focusing as much on economic reports as well as upcoming statements from policy makers and their resulting impact on the US dollar.

Perhaps the main theme of investing since summer's end has been the negative correlation between the dollar and stocks. The greenback's successive breaking of 12-month lows has provided support beneath a stock market that otherwise might struggle to find fundamentals to substantiate such an aggressive rally.

"The fundamentals are not great and I think people know that," says Peter Miralles, president of Atlanta Wealth Consultants. "A 10 percent correction would be perfectly logical to have here. This market can't keep going straight up."

A resurgence in the dollar—possible if for no other reason than nothing can go straight down and the dollar index is at a level where support has taken hold previously—seems the only thing that could shake the market long-term. Investors who have played stocks against the falling dollar have done extremely well.

"That's been such an easy trade for so long that it's become a crowded trade," says Kathy Boyle, president of Chapin Hill Advisors in New York. "If you see an unwinding of that you'll see a selloff in gold, silver, copper, the commodities, industrial stocks. That's what we see as a potential catalyst (for the market going lower). Not that the dollar has underlying fundamental reasons for getting stronger, but it's oversold."

Winterizing Your Portfolio - A CNBC Special Report
Winterizing Your Portfolio - A CNBC Special Report

Still, policy makers seem intent on keeping interest rates low, which in turn weakens the dollar. No one at the Federal Reserve or Treasury is going to explicitly back a cheap US currency, but statements from this week's Federal Open Market Committee meeting are likely to reinforce the notion that there will be no measures coming aimed at propping up the dollar.

The weak dollar, combined with an earnings season that has seen beats top misses by a 4 to 1 ratio and economic numbers that show at least tepid improvement, has some thinking that a modest correction is the worst-case scenario for the markets.

For investors who have watched the market repeatedly defy predictions for a pullback, that comes as welcome news.

"The balance of the news is pretty good. Most companies are stating that the worst is behind us," says Uri Landesman, head of global growth strategist at ING Investment Management. "It's going to be slow going, but I think directionally it's going higher."

Will the Rally Lose a Third of its Value?

Even market bears concede that after an upside-down fall, there's little reason to doubt that the normally positive months of November and December also will defy expectations and go lower.

"The wild card is they're just pumping so much liquidity into this market that we could diverge from fundamentals for a long time," says Matthew Tuttle, president of Tuttle Wealth Management in Stamford, Conn. "The trend is up and we're going to play it that way. But we're very cautious and not optimistic."

Tuttle says the Dow could break 10,000 again and then test as high as 10,500. While he believes stocks could be setting up for a major negative move—to as low as 8,200—he's not willing to bet on the timing of the fall.

In the meantime, he says he's making mostly long plays on the market while also adding a substantial gold component.

Not everyone is convinced the market is trending higher.

BofA Merrill Lynch Global Research, though long-term bullish on the market, believes a substantial correction is coming that could take hold fairly soon.

In a recent research note, analyst Mary Ann Bartels took note of "an aging rally" that she sees deteriorating on fundamentals and technical levels.

Bartels also pointed out that important market components—financials, small caps and semiconductors—are starting to weaken and indicating that the market could test its 200-day moving averages.

"The leadership areas of the market are breaking down, pointing to further downside risk to the market," she wrote. "The market has had negative divergences for weeks, meaning the new recovery highs were not confirmed by breadth, volume or price momentum indicators."

In the short term, the firm forecasts that the S&P could lose about a third of its rally, to 935, before recovering in 2010 to the 1200-1325 range.

For longer-term investors such a move won't be a problem. But in the short term, the waters could get a little rough.

"Our strategy is just to hang tough, to opportunistically pick off things that appear to be oversold," Landesman says. "At this point we're closer to my bottom than my top, so I'm disinclined to take off a lot of risk."

At the same, this point last year saw many managers take profits in anticipation of rocky times ahead.

Should the outlook for the dollar—or any of the market's other major variables—change, that could take all bets off the table.

"If you know where the dollar is going you're going to see programmed trading kick in and move the market higher," Prudential's Krosby says. "The market is watching so many variables that I think if you're a manager you may have the chance to lock in your gains, and you may lock in early."