Week Ahead: Stocks Look to Spring Ahead if Tax Cuts Hold

Stocks head toward the year end on a tail wind, but traders are watching a number of cross currents that could hold back gains in the week ahead.

Man signing tax form
Anne Rippy | The Image Bank | Getty Images
Man signing tax form

The biggest event for markets are Congressional votes on a tax package compromise that would extend Bush-era tax cuts for two years and provide a one-year break on Social Security taxes for individual tax payers. Wall Street has already embraced the plan and has factored in more robust economic growth for 2011, and higher stock prices, because of it.

Goldman Sachs chief strategist David Kostin is one of those who recently issued a forecast for 2011. He expects the S&P 500 to reach 1450 by the end of 2011, and that is because of the prospect of better economic growth.

"It's really about the U.S. recovery, and you look at election cycles. The third year of presidential terms are historically good years for the stock market," Kostin said.

The other big event in the coming week is Tuesday's Fed meeting, which is not expected to generate any major news. The Fed is expected to use its post-meeting statement to do little more than restate its flexibility on its controversial quantitative easing program. There is also a full calendar of economic reports, including retail sales, and consumer and producer inflation data.

The tax plan is likely to pass, despite the fact it is meeting resistance, said Potomac Research Group chief political strategist Greg Valliere. The plan is before the Senate Monday and probably before the House later in the week.

"As long as rate increases are reasonably steady, then it wouldn't be a cause for concern...In an absolute context, rates right now are 3.25 and that, on a historic basis, is extremely low. But an important aspect of this is why rates are up. Rates are up because the prospects for growth are higher." -Goldman Sachs, David Kostin

"I think the question is when do we get it. There's a remote chance they won't get it done by the Christmas break...I think the Democrats are foolhardy if they don't do it, and wait for January because they've got a new, much more conservative Congress coming in," he said.

Stocks in Bondage?

Another major force being watched by traders is the sell off in the bond market, which has sparked an unexpected run up in interest rates. The yield on the 10-year rose to a six-month high in a volatile week of trading. Even after most traders had left for the day Friday, the 10-year continued to tick higher and was at 3.319 percent in late afternoon. Some stock traders say they will worry if it begins to head toward 4 percent.

"As long as rate increases are reasonably steady, then it wouldn't be a cause for concern," said Goldman Sachs' Kostin. "...In an absolute context, rates right now are 3.25 and that, on a historic basis, is extremely low. But an important aspect of this is why rates are up. Rates are up because the prospects for growth are higher."

Pimco strategist Tony Crescenzi agrees rates are rising on better economic news. Pimco Thursday moved its 2011 forecast to growth of 3 to 3.5 percent from 2 to 2.5 percent because of the hefty stimulus from the tax package.

"(10-year) Treasurys (yields) have largely held in a 3 to 4 percent range...it seems that the 3 to 4 percent range is the range that's likely to hold in tact for awhile. A move above 4 percent entails many months of strong employment gains...we're not even close to the point where we'd have reason to be above 4 percent on that basis," Crescenzi said.

David Ader, chief Treasury strategist at CRT Capital, said some of the action in Treasurys is the result of year-end positioning. He believes about 80 percent of the big bond selloff was the result of overly aggressive positioning ahead of the Fed's quantitative easing program.

The Fed, in November, said it would purchase $600 billion in Treasurys, a plan that was expected to drive interest rates lower. But the Fed first started talking about easing in August and that drove speculative buyers into bond market, sending rates to the low of the year in October. Once the Fed started buying Treasurys, bonds started to sell off and rates began to rise.

"To the extent that this was a painful unwind of positions, I think people have gone from long to flat to a little degree short...It looks like it should have run its course," Ader said of the selloff. He said some of the selling is also related to fears of greater U.S. deficits, and the fact than the tax vote has sparked a bipartisan feud is not a good sign for future cooperation on fiscal matters.

Crescenzi said he believes yields might have been even higher at this point, were it not for the Fed's quantitative easing program. For that reason, he expects the Fed to continue with the full amount of QE, despite speculation that a stronger economy may reduce the need. The Fed easing program is helping reflate the economy, in that it is driving investors to riskier assets, like stocks. Crescenzi also expects the Fed to restate its commitment to QE in its statement Tuesday.

"It will be indicated somehow that current policies will be sustained. There will be no hint contained in the statement that some alternative is being considered, like the purchases will be curtailed," he said.

Keeping a Close Eye on China

Investors are also keeping their eyes on the possibility of a weekend rate hike from China, and the meeting of European heads of state late in the week.

Forex.com's Brian Dolan said the anticipated rate move by China, already a factor in commodities selling this past week, could be a catalyst for more profit-taking. He does not expect European leaders to take any significant actions that would impact the sovereign debt situation. "The spreads have started to back up in the Euro zone periphery versus Germany. If that continues, the euro is going to keep under pressure," he said.

The dollar in the past week rose about 1.4 percent against the euro and 1.5 percent against the yen, helped by U.S. higher Interest rates.

Even with the rate rise, stocks in the past week gained, with several indexes touching multi-year highs. The S&P 500 rose 1.3 percent to 1240, its highest level since September, 2008, while the Nasdaq rose 1.8 percent to 2637, its highest close since Dec. 31, 2007. The Russell also was a winner, up 2.7 percent at 776, its best close in three years. The Dow was the laggard, up just 28 points, or about 0.25 percent at 11,410.

Whither Markets?

Goldman's Kostin said he's spoken to more than 100 clients since announcing his 2011 call earlier this month, and he says many are not as bullish as he is. Kostin said 2011 will be the first year in several where the stock market could be driven by U.S. growth.

"It's about being cyclical versus being defensive, and the idea that growth is continuing is a fundamental building block for our strategy in 2011, in contrast with the strategy of the last couple of years," he said.


He said one area he has been particularly focused on is return-on-equity, and he expects it to continue to improve. In 2010, return on equity was 15 percent, and he sees 117 percent in 2011 and 18 percent in 2012. He said investors should focus on return on equity to evaluate the quality of earnings.

"The reason return-on-equity is important because it relates to price-to-book, and it's a way of combining both growth and valuation in the same analytical framework," he said.

Price-to-book is currently 2.2 times. Based on historic analysis, a 17 percent return-on-equity implies 2.6 price to book. "The idea that the return-on-equity is linked to a price-to-book valuation construct supports a price target much above what we have," he said.

What Else to Watch

The important piece of economic data in the week ahead is retail sales for November, released on Tuesday. That is being watched closely for signs of consumer strength during the holiday season. Holiday sales results are also being closely followed.

The busiest shipping day of the holiday season is expected to be Monday. Fed Ex, meanwhile reports earnings Thursday. Retailer Best Buy, a good barometer for consumer electronics sales, is reporting earnings on Monday. Research in Motion, Oracleand General Mills report earnings Thursday.

Other economic reports include producer prices on Tuesday and consumer prices Wednesday. Business inventories are reported Tuesday. The Empire state survey and industrial production are Wednesday. The Treasury also releases international capital flow data that day. Weekly jobless claims are Thursday, as are housing starts, and Philadelphia Fed Survey. Leading indicators come out Friday.

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