Stocks in the week ahead: Riding the wave

With the European debt crisis somewhat taking the backstage over the past week, the most important event in our view was the agreement reached by the Obama administration and the Republicans over the extension of the George W. Bush tax breaks.

At a cost of USD 700 billion (to be added to the national debt, of course!), the agreement cleared a major hurdle for the stock rally to find renewed impetus. Another market that took notice of the political deal was the bond market, with the yield on 10-year treasuries rising sharply above the 3% key level on the news:

 

We have no doubt that the recent increase in long yields will soon be used by the perma-bears as a major justification to their on-going argument that stock markets are about to collapse.

Call us naive, but we believe that the rise in yields may well be a sign that the tide is turning against deflation. Hence we see this development as part of the process of recovery and potentially very positive for 2011.

Obama tax breaks, Christmas rally, Central Banks Puts… whatever the reason behind it, the S&P500 is still in rally mode and our long advertised 5-wave cycle is still playing out nicely. As we suspected, we are now in the fifth-wave of a 5-wave move and the question now is (as always ), where are we headed?

Following the logic of the cycle and knowing how 50s and 100s attract trading activity on the S&P500 and its components, we expect the index to close in on 1250 by next week and hover around the level for a bit.

We also note how 1220 provided good support after the dynamic break of the previous week, despite the printing of a very bearish shooting star mid-week:

Ultimately, a wave of equal length to the “July 2010” move would bring the S&P500 towards 1291. We therefore look for the 1300 round number to be reached in the coming few weeks.

A level of 1300 points would mean that the S&P500 trades at a 15.2 forward Price Earnings ratio (2011) versus the current level of 14.4, nothing too taxing. From the 1300 level, we would then prepare for some kind of correction.

In Europe, we warned traders last week not to try and fight the ECB by shorting stock indices . Instead, we were preparing for the Euro Stoxx 50, the European benchmark for large caps, to recover towards the middle of its recent uptrend:

 Euro Stoxx 50 cash index (Daily chart), source Bloomberg

Europe was therefore a strong relative performer versus the US.

Looking forward to next week, we expect the Christmas rally to continue and the index to settle closer towards the 2900 level, with 2800 the obvious support zone of this V-shaped index recovery.

Have a safe trading week!