Santa Rally Off to Good Start But Could Still Be Bumpy Ride

Under normal circumstances, December is both a quiet and profitable month for investors: Gains are tucked away, books are closed out, and Wall Street waits for Santa Claus to come with his traditional rally to place under the tree.

Tired Santa Claus
Tired Santa Claus

But this is quickly shaping up to be no normal December.

With worries about European debt, important decisions in Washington and the effect of Federal Reserve policy looming ahead, the market could be just as easily setting up for a "Santa Selloff."

"This December...holds the key for much of the narrative in the capital markets for the next 12 months," Nicholas Colas, chief market strategist at BNY ConvergEx, wrote an analysis earlier this week.

December has certainly gotten off to a strong start. A turn in economic data sparked a huge rally Wednesdaythat wiped out half of November's losses, while markets continued to strengthen on Thursdayamid somewhat mixed economic news.

Whether that momentum holds will depend on a variety of issues, including the European sovereign debt crisis. But while Europe is the most visible issue for the market now, it's hardly the only thing that will influence trading through the end of 2010.

Congress continues a heated debate over whether to extend the across-the-board tax cutsenacted in 2001 and 2003. The current tax levels are likely to hold for lower earners, but there remains great division over what will happen to those on the upper end of the income bracket. (click here to see list of taxes set to expire)

"If they don't extend them at all levels, if they extend for all but the quote 'wealthy,' the practical reality is they are enacting a tax hike on the nation's biggest investors and biggest job creators," says Chip Hanlon, president of Delta Global Advisors in Huntington Beach, Calif., and head of Red County, a Web site that espouses conservative political values. "Setting aside the philosophical and moral questions, it boils down to where you believe jobs come from."

Indeed, political questions as much as anything are reason for hand-wringing by investors hoping that the market can extend its 6 percent gains so far in 2010 for one more month.

History, for sure, is on the side of the optimists.

Since 1945, December has been the Standard & Poor 500's best month, with an average gain of 1.7 percent while going positive 77 percent of the time. Factoring in the month's performance in years of mid-term elections and after a positive September and October add ammunition to the belief that this year will follow suit.

"The market's performance in December has traditionally been quite favorable, as it has risen the highest, and stumbled least frequently, of all months," Sam Stovall, S&P's chief market strategist, wrote in a research note. "What's more, market tops and bottoms have rarely occurred in this month. So even though history offers no guarantees, it delivers reassurances."

But those reassurances may be cold comfort if the European debt situation worsens, as Pimco's Mohamed El-Erian and others predict will happen.

While presenting its own danger in destabilizing the global economy, the problems also undermine the Fed's efforts to pump money into the economy through its quantitative easing program. The moves to buy Treasurys are targeted at lowering interest rates and indirectly at weakening the dollar, but instead have driven investors into the US currency as a safe haven and have sapped risk appetite.

"The headwinds out there are insurmountable," says Walter Zimmerman, chief strategist at United-ICAP in Jersey City, N.J. "Central banks have only undertaken quantitative easing under environments in which it is most unlikely to succeed. It comes with the territory...You do it as a last resort when you've tried everything else."

Economic fundamentals remain too weak for the Fed's push for risk-taking to work, he says.

"The economy in our view has not begun to start recovering from the real estate debacle," he says. "That continues to unfold. Unemployment continues to be chronic."

Fiscal policy also is rattling investors.

The Federal Reserve's indication Wednesday that it will backstop a bailout for Europeonly exacerbates the debt and deficit spiral in which the US has found itself.

Credit Suisse analyst Douglas Cliggott warned that Fed policies are risking consumer price inflation and could act as an obstacle for investors as "the extreme mismatch between government spending and government revenues is weighing on P/E multiples." Cliggott suggests policy makers institute measures that cut spending sharply and increase some consumption taxes.

"If elected officials in Washington get serious and start to make tough decisions about what entitlements will be cut and whose taxes will be increased, the outcome could be surprisingly positive for US equity investors," Cliggot wrote in a research note.

Stocks have managed to hold fairly steady, despite the gathering clouds.

"The US market has so far held up in the face of a lot of negative geopolitical news lately," says Beth Larson, principal at Evermay Wealth Management in Washington, D.C. "The fact that we haven't retraced much ground is a positive for the US market."

But despite the recent rally and the seasonal hopes that Santa could yet visit Wall Street, strategists are staying cautious.

"We're underweight stocks, looking for the market to pull back modestly over the next couple of weeks," says Jeff Kleintop, chief market strategist at LPL Financial in Boston. "The bias is to the downside, whether it's in North Korea or the uncertainty about taxes. But looking out a couple weeks could be a good buying point for that Santa Claus rally."