Stocks may have kicked off 2011 with a no-holds-barred surge but anyone predicting a sustainable rally through January may be overly optimistic.
Many warning signs reveal a market that is ahead of itself after the best December for U.S. stocks since 1991.
More signs of economic expansion in key economies, accommodative U.S. monetary policy, and upbeat forecasts for corporate earnings underpin the latest moves higher.
But the question now is how much of last month's gains were robbed from January.
I do think that the best December for equities in almost 20 years has likely brought forward some of the performance we might typically see in January, so I expect the pace of the market's advance to slow, said David Joy, chief market strategist at Columbia Management, who helps oversee about $340 billion in assets.
Some caution is also warranted by recent peaks in investor sentiment, said Joy in an e-mail. Major investors often warn that when most in the market become bullish it can be a sell signal as it indicates all the good news has been discounted.
Still, Joy and others said the bullishness is largely well placed, buoyed by an improving economy, growing earnings and reasonable valuations for stocks.
The CBOE Volatility Index <.VIX>, a barometer of investor anxiety known as the VIX, slipped 10 days ago to its lowest level since mid-April, just before an equity rally fizzled.
In perhaps another sign of froth, a sentiment survey by the American Association of Individual Investors hit a six-year high of 63.3 percent, also in the week of December 23, but in the latest week that outlook pulled back to 51.6 percent.
While sentiment at extremes is always worrisome, Joy noted that only recently have equity funds begun to attract net new money, suggesting markets can climb higher.
Weekly investment flows into U.S. equity mutual funds were positive for the first time since the end of April, according to the latest data from the Investment Company Institute. Flows totaled $335 million in the shortened period ending December 21, compared to outflows that averaged $3.02 billion during the prior 33 weeks, ICI data shows.
As for the earnings outlook, projections for 2011 remain strong and could help to extend the market's rally.
Earnings for companies in the Standard & Poor's 500 Index <.SPX> in the fourth quarter are expected to increase 31.9 percent from a year ago, according to Thomson Reuters data.
Overseas sales, especially in emerging markets, will be a key profit driver for many U.S. companies this year, as will such sectors as materials and industrials, which led gains in 2010. Healthy corporate balance sheets should also bode well for corporate profitability in 2011.
Also helping stocks is the so-called January effect, when retail investors pour money into their retirement accounts and portfolio managers buy stocks they expect to perform well in the coming quarter and further into the year.
Come January all of a sudden there is a big influx of cash that comes into funds that they need to put to work, said Marc Pado, U.S. market strategist at Cantor Fitzgerald & Co. in San Francisco.
The first day of the new quarter, new year, it's an opportunity to invest in some names that you won't have to show your investors for awhile, Pado said. So they are looking for names and that is really what the whole January effect is all about.
But the outlook isn't entirely sunny. Paul Hickey, an analyst at Bespoke Investment Group in Harrison, New York, said last week that throughout December the S&P 500 closed at over-bought levels as defined by the index closing at one standard deviation above its 50-day moving average.
Still, historical data suggests strong performance for the following month after such high signs of an overextended market in the previous month, Hickey said.
In the view of Bruce Bittles, chief investment strategist at Robert W. Baird & Co, the largest negative looming for investors is the market has rallied for four months and sentiment has entered extreme territory.
This raises the prospects of a pull-back early in the first quarter that we anticipate will be limited in both time and price. Looking further out, the weight of the evidence continues to point to higher prices in 2011, Bittles said in a note to investors.
The Wilshire 5000 index <.W5000>, the broadest measure of the U.S. equity market, has gained 21.75 percent since August 26, the day before Federal Reserve Chairman Ben Bernanke announced plans to loosen U.S. monetary policy further.
(Additional Chuck Mikolajczak and Caroline Valetkevitch)
(Reporting by Herbert Lash; Editing by Andrew Hay)