NEW YORK (CNNMoney.com) -
Although a bumpy December took the sheen off the fall rally, stocks are still poised to end 2005 in the black. And that's a good thing, because the first half of next year could be tough, market watchers say.
Stocks zigzagged for much of the year before finding some momentum in the fourth quarter -- a typical pattern for the market. However, the strong October-November rally lost steam in December, leaving the overall gains for the year modest.
As of Thursday's close, the S&P 500 index is up 3.5 percent for the year, the Nasdaq composite is up 2 percent and the Russell 2000, which measures small caps, is up 4.1 percent. The Dow 30 is roughly flat.
Most of the gains were the result of the big fall rally. Analysts argue that the rally may be the last big move up for stocks for some time, until perhaps the second half of 2006.
"On the positive side, you still have seasonal factors working in your favor early next year," said Paul Levine, president of money manager Lifetime Financial Strategies, noting holiday bonus money and other inflows early in a new year.
But countering that is worries about the country's growing debt burden, both for consumers and for the government. Some analysts think the dollar could weaken next year, which could also be negative for stocks.
And there's the threat to consumer spending from the slowing housing market, which cuts into refi money, and stubbornly high energy prices, which reduce disposable income.
Add to that the fact that the three-year bull market is getting a little tired, and there's plenty to be concerned about.
"The other big negative is the historically powerful trend of the presidential cycle," Levine said, referring to the theory that markets follow the four-year cycle of the presidency -- in this case, President Bush's second term.
According to that theory, the first two years of a presidential term are the worst of the four for stocks, as the party in power makes tough decisions on taxes, the economy and other issues. And of the two first years, the second year is the toughest.
"Mid-term election years are typically bear markets," said Jeffrey Hirsch, editor-in-chief of Stock Trader's Almanac.
But they can also be turnaround years, he said, noting that after a rough spring and early summer, the market tends to bottom during the dog days, creating a good buying opportunity for investors.
In the first quarter of such years, January tends to be the weakest month, as opposed to other years when it's typically a good month, Hirsch noted.
On average, since the Nasdaq's inception in 1971, the three major gauges have lost at least 1 percent in mid-term Januarys. February tends to be fairly flat and March is generally an up month, he added.
"I think early January should live up to its reputation as a pretty good time of year for stocks," said Timothy Ghriskey, chief investment officer at Solaris Asset Management.
"But the second half of the month and February tend to be a lot choppier," he added, as portfolio reallocation kicks in and people sell stocks to raise money for taxes.
Of course a lot of that could end up depending on the economy, and on the Fed, market watchers said.
Many economists are forecasting an economic slowdown next year. (Full story.)
Such worries were amped up this week when the ten-year note yield fell below the two-year note yield on Tuesday, Wednesday and Thursday -- a so-called inversion of the yield curve which can indicate a recession is ahead. (Full story.)
The interest rate question
As Federal Reserve Chairman Alan Greenspan winds down his term, Fed watchers are hoping that the central bank may be winding down its 18-month rate-hike campaign as well.
In mid December, the Fed raised the benchmark fed funds rate for the 13th consecutive time, as had been expected. But the central bank's policy makers also changed the language in the accompanying statement, suggesting to some investors that an end to rate hikes could be near.
The fed funds rate, an overnight bank lending rate controlled by the Fed, currently stands at 4.25 percent.
"If we are nearly at the end of the rise in interest rates and if bond prices can rally off that, driving down the yields, then that would provide some stronger footing for stocks in the first quarter of next year," said Steven Goldman, market strategist at research firm Weeden & Co.
"But if that doesn't happen," he added, "stocks will be vulnerable."
Goldman says that while he thinks the end of rate hikes is reasonably near, the bond market's already anticipated this, therefore he is skeptical of whether bond yields will fall enough to help stocks.
Goldman's guess is that the Fed is probably two or three more quarter-point hikes from being done. The central bank's next three meetings are in January, March and May.
But even if the Fed does pause or end its campaign as soon as March, that's not necessarily going to be helpful for stocks right away, said Ken Tower, chief market strategist at CyberTrader.
"For many, the bullish case for next year is partly dependent on the Fed stopping its rate hiking," Tower added. "But historically, the Fed stopping isn't necessarily bullish for stocks. It's when the Fed lowers rates that it's bullish."
Typically, there is a long lead time between the Fed ending a string of rate hikes and starting to cut rates, he added. And with economic growth as strong as it's been, the Fed may be forced to keep raising rates a bit longer than some are expecting on Wall Street.
What could potentially support stocks at least in the early part of the year, the analysts say, is the resilience of the economy, and the ongoing strength of corporate earnings.
S&P 500 earnings are expected to grow just under 13 percent in the first quarter of next year, said John Butters, senior research analyst at tracking firm Thomson Financial/First Call. Second-quarter growth is expected to be slower and the third quarter could be weak, he said.
But overall, the S&P 500 is expected to see earnings growth of just over 13 percent next year, the same as this year.
This is an update of a story that ran on December 15, 2005.
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