Sharon Terry

The January effect is actually a low quality effect. You see it in the small caps. You see it in the low quality bonds. You see it in emerging markets around the world, said Richard Bernstein, chief investment strategist at Merrill Lynch. This happens more powerfully when following a year when they underperforms. You could have a pretty big January effect. But he also said it has nothing to do with fundamentals, and it could be short lived.

Some traders are still holding out hope that a Santa rally will sweep stocks higher in the final week of the year, though there is no expectation that volume will improve until January. They also caution that a new round of hedge fund redemptions could pound the markets early in the year, dampening any January buying.

I really think the biggest indicator is the Treasury market. That is the absolute number one thing to watch, said Patrick Boyle of LaBranche Financial. These big funds and investment banks and governments around the world are long U.S. Treasurys for liquidity purposes. As they roll out of Treasurys, he said money should flow into stocks.

If in the first couple days of January, Treasurys continue to look strong and people still hate the market, look out below, he said.

On the economic front, markets have few data points to watch in the coming week. Consumer confidence for December is reported Tuesday, as is Chicago purchasing managers data and the S&P/Case Shiller home price index. On Friday, ISM manufacturing data is reported. Starting Friday, hundreds of economists, and some Fed officials, convene in San Francisco for the annual American Economic Association convention, which runs through Jan. 5th.

Stocks are closed New Year’s Day, but trade in normal sessions on New Year’s Eve and again on Friday.

New Year Optimism?

Bernstein said there are some signs of improvement in terms of the stock market, but he remains very cautious. In the last four months, what’s happened is the market has been sucked back to fair value. I wouldn’t say the market is demonstrably undervalued, but clearly valuations have dropped a lot. (Earnings) estimate revisions, which we use as a contrary signal, are showing analysts are finally capitulating, said Bernstein.

Last month for the first time in 10 years, people are paying a premium for low beta stocks, he said, adding that was another positive. He said now stocks like utilities and consumer staples, more steady performers, are being valued for their reliability.

But there are still plenty of hurdles for stocks. I still think equity investors have no conception of what’s going on in the fixed income markets, or what’s not going on, he said. Rates are coming down so that’s good, but to some extent rates are lower, spreads are still pretty wide.

Bernstein said he watches weekly jobless claims closely, and he does not agree with the conventional wisdom that jobs data is a lagging indicator. If employment continues to deteriorate, it makes no difference what happens to rates because nobody’s going to qualify, he said. Jobless claims, reported on Christmas Eve, were at a 26-year high.

In my mind, you will know we have a real solution to the problem when they begin to facilitate consolidation in the financial sector, he said. This is no different than Pittsburgh in the 1950s. He said the financials, like the steel industry, have to shut down operations and pare back workers because of slower demand. More mergers in the industry are necessary to resolve the issues of overcapacity.

Econorama

Deutsche Bank chief U.S. economist Joseph LaVorgna said the most important data in the coming week will be the S&P Case Shiller home price data. November existing home sales data, reported Wednesday, showed a steep decline of 13 percent in prices, the biggest drop on record. Housing prices are collapsing at an accelerated pace. It’s good only in that we’ll get to a bottom faster, he said.

The decline in housing is very important. It hurts confidence. it hurts spending power, he said.

LaVorgna said he expects the results of the holiday shopping season to be weak and there may be more anecdotal evidence of that in the coming week as retailers continue to slash prices in post holiday sales. He has expected fourth quarter GDP to come in at a negative 4.5 percent.

For next year, he said the change in administrations in Washington may help sentiment. President-elect Barack Obama’s promise of a large stimulus package early in his term may help the economy. He also said the euphoria and optimism about the new Administration, along with policy actions may create some traction. Basically that could feed on itself a bit, he said.

I think as long as the unemployment rate drifts upward through the whole year, regardless of what fiscal plans are put in place, it’s just going to keep a damper on things. I don’t think you’re going to see the economy come rip roaring out of this, he said.

Bernstein also said fiscal stimulus should be a positive for the economy, but he said it may already be priced into the market.