The stock market's performance for 2011 is coming down to whether European leaders or Santa will have control of markets in the final weeks of the year.
With the S&P 500 basically flat for the year, after months of volatility, the final weeks of December have become key to the whole year's performance for stock market indices. The S&P is hovering just under 1260, a key area of resistance.
"We could be here at the end of the year, or maybe be a few percent below where are are right now, or be up 8 percent!" said Mark Luschini, chief investment strategist at Janney Montgomery. "I don't recall a game of standoff that is so obviously macro-related as to what we're seeing right now."
The Dow is the only real winner, up about 5 percent for the year. On Tuesday afternoon, the S&P was on both sides of unchanged, and closed at 1258, up just under 0.1 percent for the year. The Nasdaq was down 0.1 percent for the year.
Analysts have been saying the potential is there for an old-fashioned, year-end Santa rally. But first the EU summit Friday needs to end on a positive note, with a unified Europe moving toward a plan to stem the sovereign debt crisis.
"Our likely scenario is that there will be something (from the EU summit) that will be enough to provide some relief from the most acute aspects of this sovereign debt crisis," said Luschini.
December historically is a positive month for stocks, moving higher 81 percent of the time since 1990 for an average gain of 2 percent, according to Birinyi Associates. This year, the S&P is up 0.9 percent month-to-date.
"Investors sound like they're picking up some Christmas spirit and that should help the market," said Jack Ablin, CIO at Harris Private Bank. "It's clearly all psychological and I think attitudes are improving, at least among institutional investors."
Strategists, however, don't expect the rally, if it does materialize, to extend much into 2012. Several see relatively small gains for next year as the U.S. economy grows sluggishly, Europe potentially slides into recession and China risks a hard economic landing.
Stocks have been whipsawed by months of misfires, then progress, then more misfires by Europe's leadership as they struggle to take their loosely held union to the next step of fiscal unity.
"The (European) problems are not going away, but it's sounding like they're trying to get their arms around it," Ablin said. "If they can coordinate policy with a much more flexible central bank, they can take a much longer term view of their problems."
Last week, the European Central Bank, the Fed and four other central banks stepped in to extend swap lines and make dollar borrowing cheaper for strained European banks. At the same time, the ECB appeared more accommodative and key leaders seemed to be moving in a more collaborative way. Markets improved, and U.S. stocks have gained about 8 percent since a week ago Monday.
German Chancellor Angela Merkel and French President Nicolas Sarkozy this week continued the appearance of progress. They met Monday and announced intentions to change the EU treatyto allow for a tighter fiscal unity and oversight.
Standard and Poor's, after Monday's bell, said it was putting 15 of the 17 EU nations on credit watch for a possible downgrade, and on Tuesday it said it was putting the European Financial Stability Fund, or bail out fund, on credit watch as well. Markets were rattled by the move and European stock markets ended Tuesday lower, while the Dow and S&P scored slight gains.
"Our year-end target was 1260 (on the S&P). I wouldn't be surprised if we didn't push it a little further," said Barry Knapp, head of equity portfolio strategy at Barclays. "That also supposes that we break the problem of (European leaders) over promising and under delivering, and everything comes out great."
Knapp said he expects stocks to have a rocky start to 2012, and his target is 1150 for the first half. But by year end, he expects more clarity around the European situation and U.S. election and he sees the S&P going to a level of 1330.
Not all analysts have visions of a Santa rally.
"This December may be the exception for a year-end rally… we’re in the eye of the storm," said Bruce McCain, chief investment strategist at Key Private Bank.
"We may have seen the peak for this rally at the end of October. The closer we get to 2012, the poorer the outlook. Europe’s economy is tilted into recession or at least toward significant slowing and we don’t see any significant solutions in the near term to lift [Europe’s] economy," he said.
Marc Pado, market strategist at Cantor, Fitzgerald, said there's a tug of war as the market focus swings between the negatives around Europe and signs of an improved U.S. economy.
"The market is trying to decide whether we're going to go higher or going lower...You could easily back down to the 1220 level and it would be really hard to go back up for the last few weeks of the year," he said.
The outcome of the EU summit will decide the path, he said.
"It won't be a Santa rally until next week. Right now, the focus is shifting to Europe. The Santa rally is really about earnings. It's about the winners and losers for the year. It's about positioning portfolios for how you want them to look for the end of the year. It's about chasing performance. Even if you went the whole year not owning Apple, if you don't own Apple, you're going to look like an idiot," Pado said.
Fund manager behavior at year end is obviously also driven by the market's performance. "In bad years, there's more pressure to dress up the portfolio. In good years, you're chasing it," he said.
The "Stock Trader's Almanac" describes a year end rally as a "short, sweet, respectable rally" within the last five days of the year and the first two days of January. It says the rally has provided an average gain of 1.5 percent gain since 1950.
Santa's failure to show tends to precede bear markets, the Almanac says.
LPL Financial chief market strategist Jeffrey Kleintop said he thinks a Santa rally could be in the offing, and that it will deliver single digit gains for the year.
"This has been the year of the stock market cliché in that all of the time-worn axioms based on the calendar actually were worth following this year," he wrote in a quick email.
He pointed to the January effect, where the S&P posted a 2.3 percent gain in January. The "sell in May and go away" theory, and the "October bear killer" both worked this year. On Oct. 3, the market bottomed, ending the 19 percent peak to trough decline from the April 29 year high.
Kleintop said the trigger for a year end rally would be a rebound in investor sentiment as Europe averts a financial crisis; improvement in the job market and the holiday shopping season surprising to the upside, as it did last year.
Follow Patti Domm on Twitter: @pattidomm