U.S. News

Market Outlook: Caution Ahead

Phyllis Burke Goffney

The bull market roared on into a new week, with the Dow hitting its 20th record close of the year, but many analysts believe stocks are poised for a breather.

As of Monday, the Dow Jones Industrial Average has risen 25 of the last 28 trading days, The S&P 500 seems safely above the 1500 mark and about 1% shy of its record close of 1527 reached in March 2000.

"I think we're getting to the point of being overbought," Bill Nichols, senior managing director of equity trading at Bear Stearns, told CNBC.com.  "A little bit of caution should be used when you have these big moves up because we tend to have a bit of a pullback."

"We are very extended and in need of a pause to refresh," said Al Goldman, chief market strategist for A.G. Edwards.  "The environment is set for a very normal pause, particularly when I see people say we are never going to correct."

Shifting Focus

Corporate earnings and reports of mergers and acquisitions drove the markets last week. Alcoa's $27 million offer for Alcan Monday provided another M&A lift but earnings will wind down this week and the economy will assume greater attention.

"I think we start to shift our focus," said Steven Lord, chief investment strategist for The Trend Investment Group.  "After we get through earnings, we'll be looking at the economy, the price of oil and that nut job (Mahmoud Ahmedinejad) over in Iran. None of that is very good."

On Wednesday, investors will get the latest interest rate decision from the FOMC and, undoubtedly, sift through the Fed's comments for any signs of future action.  Economists expect the Fed to hold rates steady at 5.25%.  Wall Street will also get more economic data including retail sales numbers and the producer price index.

A slowing economy, the slump in the housing market and inflationary pressures have prompted analysts to look for good economic news.

"This market has been one of surprise, surprise, surprise," said Peter Cardillo, chief market economist at Avalon Partners. "Even though we have a drag from the housing market, the industrial sector is doing nicely. With the exception of import prices and inflation data, I think the economic reports will come in at expectations or even beat expectations."

Expect More M&A

Even if the market takes a dip, most analysts believe there are several strong factors giving stocks support including a wave of M&A activity.  This week, Rupert Murdoch's News Corp. made a $5 billion unsolicited offer to acquire Dow Jones and there were reports that Microsoft was in talks with Yahoo either over a combination or joint venture.  Also, Reuters confirmed it received a preliminary bid to be acquired.  Several sources said Thomson was the interested buyer.

"I expect M&A to continue to be strong due to the global economy," said Cardillo.  "It isn't the only thing boosting the averages in general, but the bottom line is that it's a strong positive sentiment."

"I think the M&A activity is going to be a constant drum beat that we're going to be seeing for the next 18 months," said Peter Andersen, portfolio manager of Dreman Value Management. "Even though the consumer seems a little weak now, we have to put that in perspective and also weigh that against the very, very strong situation in corporate America right now.  We see balance sheets are very, very firm and cash has built up."

However, the constant frenzy of M&A activity is what has The Trend's Lord worried. "It's insane," he said. "How many more drinks can a drunk have. Sure, the M&A activity could continue, but this is not healthy for the markets. There are a lot of companies, like Microsoft and Yahoo, that are looking to get bigger because they can't get better."

Trade Cautiously

While most analysts appear to be bullish on stocks long-term, many advise investors to be careful in the near-term at these market levels. 

"I wouldn't disturb long-term money," said Goldman of A.G. Edwards. "But if you're looking at putting new money in the market, I would take a walk around the block and wait until we get a pullback."

"The question is, Do you fight a charging bull?" said Cardillo.  "Long-term, I'd agree with staying the course, but short-term traders should certainly be cautious.

And many analysts say, if you still want to put new money to work in this market, be selective.

"With so much investor cash sitting on the sidelines, I still think there's more momentum in this market, but you have to be selective," said Alan Lancz, president of Alan B. Lancz & Associates. "We like healthcare stocks like biotechs. I think you are going to see more acquisitions with large pharmaceuticals trying to replace their patent revenues. There are still opportunities to make money even with the market advancing."

Phyllis Burke Goffney is a news editor for cnbc.com.  She can be reached at phyllis.goffney@nbcuni.com.