Get ready. The last trading week of the year will be a test for stocks to prove whether they have the strength to carry a rally into next year.

The broad S&P 500 index broke through its 200-day moving average on Friday after turning positive for the year as a four-day rally lifted stocks following a spell of better-than-expected economic data. At Friday's close, the S&P 500 was up 0.6 percent for the year.

But despite the recent economic data that suggest the U.S. economy is on the right track to recovery, Europe's sovereign debt crisis is troubling investors and weighing on the market.

Many market participants are reluctant to believe in a Santa Claus rally this year, which refers to stocks' seasonal tendency to gain in the final five trading days of the year and first two trading days of the new year.

Warnings from major credit rating agencies on a potential downgrade of several European nations have kept investors on edge. After Standard & Poor's surprised financial markets back in August with a downgrade of the United States' triple-A credit rating on a Friday evening, investors worry a similar move could come at any time - even between Christmas and New Year's.

But the absence of European sovereign bond auctions for the next two weeks could lend support to stocks.

The fact that there won't be a (European) bond auction until the second week of January, that takes away some spotlight from Europe, at least for a little while, TD Ameritrade chief derivatives strategist J.J. Kinahan said.

Unless we get earth-shattering news, the S&P could go up to (the) 1,300 levels, he said.

The S&P 500 closed on Friday at 1,265.33.

The correlation between U.S. stocks and European sovereign bond yields has been high, especially the link with Spanish, Italian and German bonds. A poor bond auction in any one of these countries could trigger an instant selloff in the U.S. stock market.


What happens next week is important as it sets a tone for the coming year.

If Santa should fail to call, bears may come to Broad & Wall, so goes the Wall Street adage, according to the Stock Trader's Almanac.

Ari Wald, a technical strategist at Brown Brothers Harriman, said the key level on the S&P 500 to watch is 1,260, which is a resistance from the index's downward sloping 200-day moving average and the downtrend connecting its October and December peaks.

A breakout above this supply would argue for continued seasonal strength through the first quarter of 2012, he said.

He also noted that 1,200 is support from the index's downward sloping 100-day moving average and the uptrend connecting its October & November lows.

A breach of this demand could stir additional technical selling to 1,130-1,150 intermediate-term support, Wald said.

With many investors absent until the start of 2012, trading volume is expected to be light, creating more volatility.

Next week's data includes the S&P 500 Case-Shiller House Price Index and consumer confidence data on Tuesday.

The Chicago Purchasing Managers Index and pending home sales data are due on Thursday. After a strong gain in November, the Chicago index is seen giving back a modest amount in December.

(Reporting By Angela Moon; Editing by Jan Paschal)