An early Santa rally could carry into year end, if Congress does not trip up and drag the U.S. economy over the fiscal cliff.
Stocks jumped for a second day Tuesday, on optimism Republicans and the White House are inching toward a deal that would bring the two sides together ahead of year end on tax breaks and spending cuts.
"Hope springs eternal," said Art Cashin, director of floor operations at UBS. "It shows you all the market cares about is they not go over the cliff. But it's pretty clear, we're not getting a grand bargain here." Cashin said the market expects at least some partial deal that will head off the reversal of dozens of tax breaks and automatic spending cuts that are scheduled to start Jan. 1 if Congress does not act.
The behavior of Congress will set the tone for markets, and so far the market is shrugging off much of the public negotiating. "I'm sure (traders) are going to listen, and if they don't get too harsh, they'll view it as posturing. Sleigh bells are ringing in the background, and they are looking for some peace under the tree," Cashin said.
House Speaker John Boehner offered a "Plan B" Tuesday that would extend the Bush era tax cuts for those making up to $1 million, but the White House rejected the idea. The White House Monday offered to extend the tax cuts for individuals making up to $400,000 from its earlier position of $200,000 for individuals. The White House also offered $1.2 trillion in revenue increases and $1.2 trillion in spending cuts over 10 years.
The rose 115 to 13,350 Tuesday, and the S&P 500 jumped 16 to 1446 and is up 2.4 percent in two days. The rose 43 points to 3054. Tech, energy and financials, the sectors of growth, helped lead the gains.
Strategists said the stock market rally could continue into year end, unless Washington somehow blows up the negotiations, triggering an instant flight from risk assets.
"Could it go into year end? Yeah," said Peter Boockvar of Miller Tabak. "When you get into the month of December and especially in the macro, you're just trading on pure momentum at this point." But he said a deal does not necessarily need to be a good one to temporarily appease the markets. "Soon in 2013, people are going to look at the details of the deal and realize the contractionary nature of it." According to the Stock Trader's Almanac, the official "Santa Rally" time frame is the last five days of the year, and the first two days of the new year.
As stocks rallied Tuesday, a selloff continued to rip Treasury pricesand drive yields higher, for the biggest two day jump since mid-October.
"I think finally people are realizing we're not going to get a recession, courtesy of the fiscal cliff," said Lord Abbett fixed income strategist Zane Brown. "We've identified what items are open to compromise. There seems to be a building of middle ground and therefore the idea of recession is even more remote. They're selling Treasuries and putting the money into something, whether that's equities or cash. The improvement in equities and high-yield bond is coincident with what's going on in Treasurys in the last couple of days, reflecting what's going on in Washington."
Brown said the selloff in Treasurys could continue, and the 10-year yield could continue to rise from Tuesday's 1.82 percent. "I doubt we're going to get any higher than 2 percent but we could reach 2 percent," he said. "A 25 basis point move would undermine everything the Fed has done so far in terms of bringing down mortgage rates."
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"It could happen between now and year end. I think it's because of people reallocating and quickly selling high quality securities and putting more risk into their portfolios," he said. He added he doesn't see any massive asset rotations yet. "It's just small shifts in portfolios," he said.
Boockvar said he doesn't see big shifts either, and stocks and bonds can both rally. "The talk of asset allocation is just nonsense. Do I see pension funds making major shifts. I think on a secular basis, they've shifted into fixed income and I don't see them suddenly shifting," he said.
Kate Moore, global equities strategist at Bank of America Merrill Lynch, said the first quarter could be rocky for stocks, but she expects to see them move higher for several reasons, including an improving Chinese economy. Europe could also begin to quiet down next year, after the beginning of the year, and the anticipated request for aid from Spain.
"We have a 1600 target on the S&P 500, looking for a new all-time high. It could be a little volatile in the first quarter of the year, which is why we're recommending investors hedge their positions going into the new year, just in case," she said.
"Our big overweights continue to be technology," she said. "We like energy stocks. We like industrials. We see opportunities across the space." She said one opportunity is in materials stocks, which have not rallied despite improving investor confidence in the global growth picture and in China, in particular.
(Read More: Fund Managers More Bullish on Economy, China)
"We've had some pretty aggressive fund flows into emerging markets over the last 12 weeks," said she. "Perhaps, they're overbought but we still see opportunity in EM in 2013."
What to Watch
There are housing starts for November at 8:30 a.m. Wednesday and a 7-year note auction at 1 p.m. FedEx, General Mills, Bed Bath and Beyond, Jabil Circuit and Paychex report earnings. Traders will be watching FedEx for any comment on the economy and the holiday shopping season.