Is Santa Claus rally almost done?

Monday, 13 December 2010 00:01 -     - {{hitsCtrl.values.hits}}

New York (Reuters): The December rally may be reaching its climax, with just two weeks to go before Santa Claus makes his midnight run. Dwindling volume, excess optimism, and history all point to a stock market that could be running out of steam.

Investors appear to have grown complacent as the CBOE Volatility Index, or VIX .VIX, has fallen to levels not seen since April. Stocks have made new highs on almost a daily basis. The S&P 500 .SPX closed on Friday at its highest level since September 2008 and the Nasdaq .IXIC scored its best finish since late December 2007, with many expecting gains to run through the end of the year.

But Cleveland Rueckert, an analyst at Birinyi Associates in Stamford, Connecticut, believes the year-end rally may be largely done.

“The majority of that gain may already have occurred,” he said. “Most people are more likely to be closing out their books at the end of the month and looking for opportunities to open new positions at the start of the next month.”

Rueckert said that over the last 65 years, when the S&P 500 has rallied at year’s end, the average gain has been 3.4 percent between Thanksgiving and New Year’s. So far, the index has risen 3.5 percent since the start of the period.

“A lot of stocks this year have had very big gains and it really wouldn’t be surprising to see a lot of the managers close out positions and take some vacation time,” he said.

When trading resumes on Monday, that will start the last five-day trading week before Christmas. The following week will be cut short by the holiday. With December 25th falling on Saturday this year, the U.S. stock market will be closed on Friday, December 24th, in observance of the Christmas holiday.

Inflation data for November will dominate next week’s economic calendar, with the U.S. Producer Price Index due on Tuesday and the U.S. Consumer Price Index set for Wednesday.

Some see signs of the bulls getting into the eggnog.

The American Association of Individual Investors’ latest sentiment survey shows bullish sentiment reached a four-week high. What’s more, bullish sentiment has spent 14 weeks above its historical average -- its longest streak in six years.

That is often seen as a contrarian indicator.

This week, the S&P 500 has broken through closely watched resistance levels and has climbed for six of the last eight days to close at fresh two-year highs.

But gains have been accompanied by decreasing participation. Average volume during the last three days of the week was 7.76 billion, well below this year’s daily average of 8.62 billion.

“We are entering now the beginning of the seasonal pattern where volume really dries up,” said Nicholas Colas, chief market strategist at the ConvergEx Group in New York. “It seems like it’s starting a little sooner than usual.

“I don’t think we’re at any risk of a meaningful sell-off into the end of the year, but I think the basic contours of what the economy looks like are pretty well set,” he said.

Chart-minded investors are bullish. The S&P 500 has closed well above 1,228, the 61.8 percent Fibonacci retracement of the 2007-2009 bear market slide, a key technical level.

“When a market surpasses a certain retracement level, then the probability increases of a rise to the next retracement level, which in this case would be a 76.4 percent retracement and that’s a ways up at 1,362,” said Chris Burba, short-term market technician at Standard & Poor’s.

The 1,120 level, the top of a recent trading range, is seen as strong support.

On Friday, the S&P 500 closed at 1,240.40 and was up 1.3 percent for the week. The Dow Jones industrial average .DJI ended Friday’s session at 11,410.32 and was up just 0.2 percent for the week. The Nasdaq closed on Friday at 2,637.54; for the week, the Nasdaq was up 1.8 percent.

An agreement to extend the Bush-era tax cuts over the next two years has started to seem like less of a done deal. The agreement is expected to be approved by the U.S. Senate on Tuesday, but could face a tougher road to passage in the House.

If the legislation stalls, resulting in higher capital gains and dividend taxes at the start of next year, then U.S. stock prices could fall.