Market Insider

As Santa rally raises stocks, traders watch bond grinch

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Stocks could be swept higher in a Santa rally, but traders are watching out for a potential party pooper.

"Beware of the bond market," said Mark Luschini, chief investment strategist at Janney Montgomery.

Treasury yields have the potential to act as a trip wire for stocks. When the 10-year edged to 3 percent earlier this year, the stock market was shaken. With the Fed now preparing to slow down its bond-buying, yields have been moving higher again, and better economic news is also a catalyst.

Stronger-than-expected consumer spending, up 0.5 percent in November, and surprisingly good durable goods, up 3.5 percent, helped drive the 10-year yield to 2.987 percent Tuesday, its highest level since Sept. 6, when it hit 3 percent.

Will this Grinch steal the Santa rally?

"Equities have had a great year. Valuations have been the driver of equity performance and valuations are full. We think we are in overshoot territory," Luschini said. "I just wonder if you see a few more good economic data points and we breach that 3 percent level."

(Read more: Cashin: The grinch that might steal Christmas?)

The finished Tuesday's shortened session up 5, at a new high of 1,833; the Dow was up 62 at a record 16,357.

According to the "Stock Trader's Almanac," a "short, sweet, respectable" rally in the last five sessions of the year and first two sessions of a new year have produced an average 1.6 percent gain since 1969.

But beware of the years when Santa does not appear. The almanac warns that those periods precede bear markets, or years where stocks get to be much cheaper later in the year.

While the "official" Santa rally is about to get underway, stocks have already been powered higher by seasonal factors for the past several weeks. The S&P is up 1.5 percent for December.

(Read more: The Fed reversestaper and other bold 2014 calls)

Early stage of bonds to stocks rotation: Pro

The Santa rally is followed by the January effect, which is the pull of money into the market for the new year. The two now run together and form a kind of "holiday cocktail," stirring up gains for the market, Luschini said.

Markets are closed Wednesday for the Christmas holiday but open for business as usual Thursday.

The only economic data for the rest of the week is Thursday's weekly jobless claims, but traders will also be on the lookout for any reports on how retail sales have fared.

Barclays economist Michael Gapin expects to see weekly jobless claims of 350,000, down from last week's 379,000, a nine-month high and the second straight elevated week.

"We think we'll retrace some of that move higher," he said, adding that he expects it to move back to its previous level. "There's a lot of noise in that series."

(Read more: Santa gives market gift of strong economic data)

Consumer spending gained 0.5 percent in November.

"We're getting further away from the tax rate increases last year, and we just have modest growth in income and further employment. We put another 200,000 people on the payrolls, and I think the wealth effect is contributing," Gapin said.

"All these things combined will move ... real consumer spending to 2.5 percent. It's been roughly in the 2 percent range in the last few years," he said.

The durable goods report was also a positive, though some economists point out that business spending could be driven by two expiring tax breaks on capital expenditures, Gapin said.

Durable goods were up 3.5 percent, with the core orders rising 4.5 percent on the month. Those orders correlate to business spending.

Gapin said GDP was tracking at 2.3 percent for the third quarter as of last week, above his forecast of 1.5 percent.

—By CNBC's Patti Domm. Follow here on Twitter @pattidomm.