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Tuesday Look Ahead: A New Rally Burst?

Monday, 22 Feb 2010 | 5:01 PM ET

Earnings strength and an improving economy could propel stocks 10 to 15 percent in another burst higher, yet that gain is unlikely to be sustained through the balance of the year, according to Citigroup chief equities strategist Tobias Levkovich.

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Levkovich said his year end target remains 1175 - just about 7 percent above the S&P 500's current level. He said stocks could rally higher to as much as 1250 but will then likely hit a rough patch as the Fed begins to drain liquidity from the financial system. The Fed Thursday raised the discount rate on short term, emergency bank loans to 0.75 percent, and the market took the move in stride.

The Fed's next step is likely to be the expected end of its program to buy mortgage-backed securities at the end of the quarter. "The Fed has used extraordinary measures to put liquidity into the system," Levkovich said, noting a string of programs that it will unwind.

"We use the mortgage-backed securities program as a very clear indication. They told us they were going to stop doing that ... you can put a check next to it on your calendar," he said. Levkovich also said it would be natural for mortgage spreads to widen once the Fed stops it purchases.

It will ultimately, though, be the Fed's move to raise the Fed funds rate that analysts say could have the most impact on the market. That rate more directly impacts consumer loans and mortgages. Citigroup expects the Fed to make its first increase in the Fed funds rate in the fourth quarter.

"If you look at the year after recessions end, earnings have gone up double digits. But the market only goes up single digits, as the Fed removes accommodation and they raise rates," Levkovich said in a telephone interview.

But first, there's potentially a decent pop coming for stocks. "95 percent of the market levels reflect no growth in earnings, based on our analysis. That is similar to 1979 and 1982, and we saw pretty big rallies thereafter," he said. Citigroup Monday raised its forecast for 2010 operating earnings per share on the S&P 500 companies to $76.50 from $72.50.

The question though is when will the market shift its focus to the elimination of easy money and other concerns, such as higher taxes.

"Indeed, some sense of solution to a variety of problems ranging from substantive domestic fiscal challenges and structural unemployment may be required before investors can be convinced of a new secular bull run," he wrote in his note today.

"We are not looking at a secular bull market until 2012. It usually takes a number of years to work through economic difficulties," he said. Levkovich said the lead up to the next presidential election in 2012 will certainly be a factor as the debate focuses on "fiscal responsibility/irresponsibility."

What to Watch Tuesday

—S&P/Case-Shiller home price data is released at 9 a.m.

—Consumer confidence is reported at 10 a.m.

—The Treasury auctions $44 billion in 2-year notes at 1 p.m.

—FDIC holds its quarterly briefing on the state of banks at 10 a.m.

—The House Energy and Commerce subcommittee on oversight and investigation holds a hearing on Toyota and NHTSA's response to Toyota's acceleration problems.

—Earnings reports are expected from Home Depot , Target ,Macy's , Office Depot,Sears , Barnes and Noble,Vornado Realty Trust, Tenet Healthcare,Medco,Garmin.

—St. Louis Fed President James Bullard speaks at 5 p.m. on regulatory reform.

Questions? Comments? Email us at marketinsider@cnbc.com

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