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Is This Market Rally Legit or Nothing but a Head Fake?

Friday, 17 Aug 2012 | 8:33 PM ET

The few people left on Wall Street in the coming week will likely debate whether the stock market is on a course to new highs, or just in the final stages of a head fake rally that will end in pain when September rolls around.

A janitor sweeps an empty trading floor at the New York Stock Exchange.
Getty Images
A janitor sweeps an empty trading floor at the New York Stock Exchange.

During the summer doldrums, stocks have continued to move steadily higher, befuddling traders and analysts, who still see Europe lurking in the background as they worry about the U.S. economy, the election and the “fiscal cliff.” (Read more: Still Fiddling While the 'Fiscal Cliff Gets Closer: Bartiromo)

“It’s like a late December move,” said James Paulsen, chief investment strategist at Wells Capital Management. “Do you really put much credence in it? If everyone comes back in the first few weeks of September and this thing continues, then more people get on board. I think a lot of people think when the players get back, this thing is going to reverse.”

In the coming week, there are a few important reports including housing data and durable goods. There are also a few big earnings, including Hewlett-Packard and Dell .

Stocks ended the past week with gains, including in the Russell 2000 small cap index and the Dow Transports, two indices that had been lagging and both up more than 2 percent. The S&P 500rose 0.9 percent to 1418, just below its April high of 1419, a four-year high. The S&P is now up nearly 12 percent since early June. The Dow, up 10 percent since June, was up a half percent in the past week to 13,275. The Nasdaq had the best gain in the past week after the Russell and Transports, rising 1.8 percent to 3076.

The stock market’s gains since June came amid signs of a slowing economy, dented by a lack of confidence and hit by a slowdown in Europe and elsewhere. But lately, the U.S. economic news has outpaced the substantially lowered expectations of economists, and analysts are monitoring the widely-watched Citigroup economic surprise index to see if it will continue to move higher. (Read more: With Expectations So Low, Economy Starts to Look Good)

The surprise index measures the actual data against economists’ expectations, and some of the data has beaten forecasts, including the July employment report and last week’s July retail sales. Just Friday, consumer sentimentimproved, rising to a three-month high and leading economic indicators also topped forecasts, rising 0.4 percent, after June’s 0.4 percent decline. While it still shows sluggish growth ahead, the improvement in leading indicators was due to a drop in jobless claims and the surprise jump in housing permits.

Paulsen said while increasingly disappointing manufacturing data has been a source of concern, the surprise index is generally consistent with what happens in the market. “If nothing else, it’s a leading confirming signal,” he said, adding its recent choppiness will probably reverse when the latest data is factored in.

The past week has also seen a return to a higher interest-rate environment, as Treasury yields continued to climb off the record lows set last month when markets were gripped by fear about Europe’s debt crisis. The better data helped send the 10-year yield as high as 1.88, just above its 200-day moving average. By late Friday, it was yielding 1.817 percent. (Read more: Interest Rates Jump to Highest Level in 3 Months)

With little to rouse markets, traders will be watching how yields continue to perform. This past week, speculation circulated that the improving data could keep the Federal Reservesidelined at its September meeting, and forecasts cropped up that pushed much anticipated Fed easing back into the end of the year, or not at all. The Fed has been expected to conduct another round of quantitative easing, or the purchase of Treasurys or mortgage securities, in an effort to keep rates low and push investors into riskier investments.

The speculation the Fed will now hold off makes Wednesday’s release of minutes of the Fed’s last meeting important, even though the meeting occurred before improvement in the employment data, retail sales and housing reports. “These minutes will reflect the dovish statements, not the data we received that has mitigated against it. One could interpret the minutes as dovish. I hope people will see through it,” said David Ader, chief Treasury strategist at CRT Capital.

Ader said yields, off their week highs Friday, may have found the top of their range for now. “The 30-year came within breathing distance of 3 percent,” he said.

As for the coming week, anything from Europe could be important but the market itself may become the story. “Price action sometimes is the news,” said Ader.

Whither Stocks

Even as stocks rise, the market has remained skeptical and investors are still fearful. The fiscal cliff, the combination of the expiration of Bush tax cuts and automatic spending cuts, looms at the end of the year if Congress takes no action. The anticipation of that event has held off business investments and already weighed on growth, according to economists.

Yet, J.P. Morgan equity strategist Thomas Lee Friday boosted his S&P 500 target to 1475 by early November. But after the election he expects stocks to fall, and his year-end target is 1430. He recommended investors move into cyclicals.

Citigroup analysts, in a note Friday, said the election and fiscal cliff could hamper further market gains, but they wrote that the Citigroup surprise index could be signaling further gains.

Savita Subramanian, Bank of America Merrill Lynch chief equity strategist, said she sees just modest upside for the rest of the year. “Nothing to write home about. For the rest of the year, our target implies 3 percent,” she said in an interview.

She said on the positive side, sentiment is very negative. Subramanian did a study this summer that showed the average equity allocation among strategists was below 50 percent for the first time in almost 15 years. It usually runs at 60 percent. (Read more: Bullish Sign? Even Wall Street Thinks Stocks Are Dead)

“Everybody’s throwing in the towel. it’s a contrary indicator,” she said.

“We’ve got conservative positioning from the investment base. Cash levels are high. There’s a real lack of conviction in the market. Those could all help to bolster returns through the end of the year,” she said.

Subramanian said she favors tech and consumer staples, but the strategy that has worked best in the last several years has been stocks that have dividend growth.

She said there are risks ahead, and investors would be wise to buy protection. She said the fiscal cliff could be a major negative if Congress lets automatic spending cuts bite into government agencies and defense spending. “Just the fact you have $750 billion in cuts on the table, and even if only half of that goes through, it’s a pretty big hit to GDP,” she said. “I think earnings would do okay, but it would stymie growth and it would be a negative for consumers and sentiment.”

As stocks crept higher Friday, the VIX set a new five-year low, indicating complacency, but the VIX futures curve through the end of the year is very steep, showing a heightened concern among investors that a spike in volatilitycould be in the offing.

Monday

Earnings: Lowe’s, Urban Outfitters

Tuesday

Earnings: Dell, Best Buy, Barnes and Noble, Williams Sonoma, Wet Seal

0800 am Atlanta Fed President Dennis Lockhart speaks

0215 pm FOMC minutes

Wednesday

Earnings: Hewlett-Packard, Kayak Software, American Eagle Outfitter, Chico’s FAS, Express

1000 am Existing home sales

1030 pm China flash PMI

Thursday

Earnings: 1-800-Flowers.com, Big Lots, Salesforce.com

0830 am Initial claims

0858 am Markit U.S. PMI preliminary

1000 am New home sales

1000 am FHFA HPI

Friday

Earnings: Pandora

0830 am Durable goods

Follow Patti Domm on Twitter: @pattidommQuestions? Comments? Email us at marketinsider@cnbc.com

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  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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