Despite Rising Odds of a Pullback, Stocks Could Still Rise Through Year-End

Stock market outlook
Stock market outlook

Stocks continue to look appealing to investors with a decent time horizon. Earnings have been very impressive, and the Federal Reserve has made it clear it sees boosting the stock market as a key to helping the economy.

Given the recent gains and with the end of the year fast approaching, where the markets heads in the near term, however, seems like a much trickier question. Calls for a dip are rising amid signs that the market is overbought. But evidence of performance-chasing, where fund managers who are lagging their peers take on more risk in hopes of outsize returns, are also mounting. That could lead overall to an upward push even as many investors rightly look for a pullback.

It's understandable why many commentators would like to see the global stock market rally go through a period of consolidation. The MSCI World Wide index had already rallied for 46 days without as much as a 2% correction, research firm Ned Davis wrote in a note to clients earlier in the month. But ever since 1972, the normal tendency has been for a correction of that magnitude to take place about every 17 days.

Could Labor Demand Be Even Stronger?

Investor optimism, too, has been rising fast and for equally good reason. Manufacturing around the world is rising sharply, and October's job growth in the U.S. trounced all expectations as payrolls expanded by about 2.5 times the 60,000 new jobs the analysts' consensus had predicted.

But the demand for U.S. labor may still be getting understated. On a year-over-year basis, "aggregate hours worked has increased 3%, the fastest since August 2006, and exceeds the payrolls' growth rate by 2.3%, the most since April 1984," Ned Davis wrote in another research note Friday.

Indeed, analysts at Morgan Stanley (MS)estimate that gains could have been as high as 240,000 and told Bloomberg News that government efforts to smooth out monthly fluctuations in the statistics may have dampened the overall figure. The firm also boosted its fourth-quarter GDP growth forecast to 3.5% from 2.5%, thanks to the firming labor market and consumer spending.

Fewer Big Buyers Left on the Sidelines?

Still, the fast-rising investor confidence -- especially on the part of the large institutional investors who tend to move the market -- could also create headwinds for the market. As more institutions throw their hats in the bulls' ring, new buyers get harder to find. And as expectations get higher, sensitivity to negative shocks grows as well.

A crowd sentiment poll by Ned Davis, for example, showed confidence climbing to a measure of 71 during the summer -- the highest since the start of the financial crisis -- before stocks sold off sharply in the following months amid fears ranging from a European sovereign debt crisis to a deflationary spiral in the U.S.

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Davis's index currently stands at about 66 after tumbling to about 41 as that last round of panic gained sway, which may have helped set the stage for the current rally.

But the time of year could make a difference this time around. As 2010 winds down, fund managers who are underperforming their rivals could get more desperate to show results. So, their propensity to buy risky assets and prop up stocks could be growing.

Sharp rallies in some highly expensive and risky technology stocks might be an indication that this dynamic is gaining steam. Shares of the Internet video renter Netflix (NFLX) have rallied more than 50% over the last three months, while the shares of online restaurant reservation provider OpenTable (OPEN) have jumped about 40%. The broader S&P has gained less than 10% over the same time.

Despite the mounting logic for a correction, then, the market could continue to power higher during the rest of the year. And propelling it would be not just the broadly rising optimism but the growing desperation of some fund managers.

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