Rally rolls on. But watch out come January

There are plenty of reasons stocks can keep rising through year-end. But 2007 will pose some challenges.

By Alexandra Twin, CNNMoney.com senior writer

NEW YORK (CNNMoney.com) -- With the Congressional elections finally over and done, the third-oldest bull market in history seems set to roll on through the end of the year. Come January, though, that could change.

Many market pros say the outlook for stocks is good the next six weeks, even though stocks have had a big run since July. They cite strong earnings, lower oil prices, a Fed that seems to be on the sidelines for now, and the belief that the economy is headed for a so-called "soft landing."


Besides, November and December are typically strong months for stocks, making the fourth quarter the best one on Wall Street.

The last roadblock for the rally was the Congressional elections, amid speculation about how traditionally Republican Wall Street might react if the Democrats took both chambers of Congress. Well, they did, for the first time since 1994. How did stock investors take it? The Dow just closed at its 17th record high since early October.

But what happens in the first quarter of next year is anyone's guess, especially if Ben Bernanke & Co. at the Fed don't hint they're getting set to cut interest rates, as many investors are hoping. (Note: Despite signs price pressures are easing, the Fed's still worried about inflation.)

What if earnings finally do slow down and grow at less than a 10 percent rate? And what if the Democrats pass a minimum wage hike, pass trade protection bills and take aim at taxes when the 110th Congress convenes in January.

Could all of that prove to be the proverbial straw that breaks the bull's back? Maybe, maybe not, but there's still plenty to give the bull a backache.

Here's what to keep an eye on heading into the first quarter of 2007.

Inflation and the Fed

A two-year interest rate hiking campaign came to a halt in August, and investors have been hoping the Fed's next move will be to cut interest rates, perhaps as soon as the first half of next year.

That assumes the economy will slow enough to counter inflationary pressures, sparking a need for rate cuts, which tend to spur growth and boost profits, giving a lift to stock prices.

But some recent economic reports and comments from central bankers have suggested the economic slowdown may be short-lived. And while inflation pressures are easing, the Fed still says inflation is its biggest worry, not slowing growth.

As the recent release of the minutes from the October Federal Reserve policy meeting made clear, the likelihood of the Fed cutting rates in the next six months is pretty slim.

In fact, there's a good chance the central bank won't cut interest rates until 2008 and some Fed officials think another rate hike may be needed first to tame still-persistent inflation.

All of which is likely to be disappointing for investors.

Earnings slow, for real this time

For 13 quarters running, the S&P 500 has posted year-over-year earnings growth of at least 10 percent, according to tracker Thomson Financial. That ties the previous longest streak of double-digit growth, stretching from the fourth quarter of 1992 through the fourth quarter of 1995.

While growth isn't expected to slow dramatically, it is expected to slow next year - another concern for investors.

Third-quarter earnings probably rose 18.8 percent, according to Thomson, with 92 percent of the S&P 500 having reported. Fourth-quarter earnings are currently expected to grow 9.6 percent and first-quarter 2007 earnings are currently on track for growth of 9 percent.

Because reported earnings tend to surpass initial estimates, fourth-quarter growth will probably keep the streak going. But the first quarter is on the fence, said David Dropsey, a Thomson research analyst.

In addition, earnings growth for all of 2007 is expected to be 9.5 percent, versus growth of 15 percent for 2006 and 20 percent in 2005.

That's partly because the economy is slowing, but also because after more than three years of robust earnings growth, comparisons get tougher.

All of which raises the question of "whether the market is prepared for decelerating earnings growth next year," said Art Hogan, chief market analyst at Jefferies & Co. He said he's not so sure that's the case, which makes stocks look vulnerable in early 2007.

But Dropsey noted that earnings growth for the quarters discussed still tops the long-term quarterly average of 7.6 percent dating back to 1954. Meanwhile, even 2007's target is higher than annual average growth of 7 percent.

"For earnings to really fall off, we'd need to start seeing flat or declining growth across the board," Dropsey said. "The fact that we're just not going to be growing in double-digits anymore isn't bad, when taken in context with what we've done for the last 2-1/2 years."

New Congress upsets Wall Street

Sure, gridlock is typically good for stocks, with markets generally doing well when the White House and Congress are controlled by different parties. But that doesn't mean the market is immune to what the new Democratic Congress might cook up.

To an extent, a lot of the Democrats' proposed agenda is "not particularly market moving," said Hugh Johnson, chief investment officer at Johnson Illington Advisors. He was referring to issues like raising the minimum wage, legalizing illegal immigrants, and even the debate over stem cell research.

In addition, issues that do impact so-called Big Business aren't likely to get passed. For one thing, President Bush still has veto power. Also, certain legislation is just not possible yet. For example, the cuts in taxes on dividends, individual income and capital gains won't expire until 2010.

However, Big Business is expected to be put on the hot seat, as Congressional committees question oil and drug executives about pricing and compensation, among other issues. That could hurt the individual stocks and sectors, and by extension, put a limit on any broader market gains.

Ancient bull gets tired

Then there's the aging bull. There are only two bull markets in history that have lasted longer than the current one, which turned four in October.

The longest bull market in history was the tech-fueled 1990s boom, according to the Stock Trader's Almanac, which measures that bull from October 1990 through July 1998, nearly eight years. The second oldest stretched from October 1923 through September 1929, about six years.

While investors are hoping the current bull has legs, analysts keep calling for a correction, considering that the Dow is at record highs and the S&P 500 and Nasdaq are at or near 6-year highs.

There are also seasonal factors at play. "Usually you get a good correction in early January, so at that point, I would raise some cash," said Harry Clark, CEO at Clark Capital Management.

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