A bout of profit taking seems likely early next year after the S&P 500 ended its best December in almost two decades, but stocks may have further to run at the start of 2011.
Technical indicators are pointing to a strained market, though recently stocks have been maintaining the momentum of late 2010.
The potential is certainly there for shares to derail next week with some important economic reports due. A repeat of last month’s disappointing U.S. jobs number could spark a sell-off.
“We think in the near term markets are getting ahead of themselves,” said Zahid Siddique, portfolio manager for Gabelli Equity Trust in Rye, New York. “The data has to be good for the markets to continue to go up, and if there is any weakness in the data, we think we could have a sell-off.”
Analysts in a Reuters poll expect the economy added 126,00 jobs in December, up from 39,000 the prior month, but still not enough to significantly dent unemployment.
A series of global purchasing managers indexes are also due next week, including the Institute for Supply Management‘s two monthly surveys. They are expected to show growth quickened in December in the U.S. services and manufacturing sectors .
An array of technical factors show the market may be at the top end of its recent trading range, but strongly trending markets often produce false signals.
“There is no denying the fact that the market is overbought,” said Paul Hickey, an analyst at Bespoke Investment Group in Harrison, New York. “The entire month of December the S&P 500 has closed in overbought levels everyday.”
Hickey considers the S&P 500 overbought when it moves one standard deviation above its 50-day moving average. But looking at prior months where that has occurred he found performance the next month was above average instead of reverting to the mean.
“Momentum tends to carry the market further,” he said.
BEST S&P DECEMBER SINCE 1991
Signs of an improving economy, tax breaks and loose monetary policy helped spur a near 20-percent rally in the S&P 500 since the end of August. The index rose 6.5 percent in the last month of the year, its best December since 1991.
The gains stalled in the last week of the year with indexes finishing essentially flat.
Siddique, who helps manage a $1.3 billion equity fund, says his firm raised cash as equities rose by paring positions in strong performing consumer discretionary and industrial sectors.
He says that worries over Europe’s sovereign debt crisis, global growth and political tensions may resurface. He is looking at defensive sectors such as utilities, consumer staples and healthcare, which have lagged.
“In some of our fund we have been increasing cash allocations,” he said. “So if there is a sell-off, we can reallocate that cash into the relevant sectors.”
The S&P 500 relative strength index, which compares price gains to losses over a given period, has been near or above the overbought 70 level for nearly two weeks.
The index’s slow stochastic and moving average convergence- divergence (MACD) levels indicate that S&P 500 may be coming to the top of its recent trading range.
Although strongly trending markets can continue in an overbought condition for some time, a convergence of those three indicators in early November heralded a 4 percent correction.
Analysts at UBS point to an 80-90 point uptrend channel for the S&P 500 with a support line linking August and November lows and a resistance line linking peaks in the same months.
That would currently place S&P support at around 1,222 and resistance at 1,314, giving the potential for a 3 percent pullback if the channel holds.
MIDTERM ELECTIONS BECKON
In 2011 the United States is also entering the third year of a presidential cycle. This theory holds that after the midterm elections presidents push less controversial legislation that could hurt markets as their sights are set on reelection.
Since 1914 the Dow Jones industrial average has gained an average of 49.3 percent over 15.5 months from its low in the midterm election year to it high in the following preelection year, according to UBS.
Transposing that onto the S&P 500 for next year could see the index peak at around 1,430 in mid-October.
But some investors who focus more on the economy and corporate results are not convinced.
Rob Russell, president of Russell & Co in Dayton, Ohio, said he expects equities to sideline in 2011 as higher corporate earnings are offset by a stagnant economy.
“Unemployment will continue to be that 800-pound gorilla,” he said. “We will continue to see, like we have for a good part of this year, a sea of contradicting economic data.”
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