Ready for a Santa Claus Rally?

Positive economic signs, rising consumer confidence, and strong retail sales could provide some holiday cheer for investors

By Marcia Vickers

'Tis the season of giving -- and most investors, true to their nature, want to know what they'll be getting this holiday. After all, stocks were rocky most of November, giving back some of the gains posted since this year's March lows. The November blahs were due largely to profit-taking by the pros who want to look good at yearend. But here's some jolly news: A December rally that lasts into the new year is quite possible.

The reason: The economy is improving steadily, fourth-quarter corporate profits look strong, consumer confidence is gaining, and retail sales are beginning to appear robust. "Over the next two weeks, it's really going to be about Christmas sales," says Christopher Wolfe, head of equities at J.P. Morgan Private Bank. "There's a decent relationship between back-to-school sales and holiday sales, and back-to-school was relatively strong. So for a Santa Claus rally to occur, that's the key component right now."

Indeed, retail stocks have been rocking. So far this year, the Dow Jones U.S. Retail Specialty index is up an eye-popping 55%. And companies like Gap (GPS ), Target (TGT ), and Wal-Mart (WMT ) have posted some hefty gains since their March lows. According to the BTM/UBS Weekly Chain Store sales index, retail sales rose 0.4% in the week ended Nov. 22 -- that's the first positive figure after two down weeks.


  Numbers like that, which hint at a stronger-than-expected period, put smiles on analysts' faces. "It's a short holiday season this year, with Thanksgiving later than usual. A good holiday season for retailers will boost consumer confidence. And the market has been paying a lot of attention to consumer confidence lately," says John Caldwell, portfolio-strategies director at McDonald Investments in Cleveland.

Corporate profits are also likely to keep warming investors' hearts. According to earnings researcher Thomson First Call, Wall Street analysts expect fourth-quarter earnings to come in 22% higher year-over-year. But Charles Hill, First Call's director of research, thinks the actual number could be even better -- as much as 25%. "We're running high in terms of positive surprises right now, and the market is going to start looking ahead," says Hill.

With investors buoyed by other healthy numbers like third-quarter gross domestic product growth at 8.2% -- the fastest spurt since 1984 -- the market could take off again. And despite all the horrific mutual-fund headlines, inflows seem to have held up. They'll likely get stronger starting in the next few weeks, thanks to the so-called January Effect -- deployment of yearend bonuses, payouts, and dividends. Also, money managers will start reinvesting cash they've had on the sidelines.


  Besides, investor optimism is soaring like Santa's sleigh. According to the monthly UBS Index of Investor Optimism released on Nov. 24, investors are more hopeful than they've been in the past 20 months. Fifty-seven percent of those polled by UBS are optimistic about the economy, vs. 43% a year ago and 50% last month. Nearly two-thirds say now is a good time to invest.

They could be right. Seasonally, the six months starting in November are historically the best months to invest in stocks -- with triple the gains vs. the other six months over the past 50 years -- according to the Stock Trader's Almanac. Of those six months, November, December, and January have posted the largest gains in the past.

Of course, not all the signs are rosy for a market run-up. Corporate spending still needs to pick up, and the job market must strengthen for a sustained bull market, say the pros. Iraq continues to cast a wide shadow of doubt, and of course, unforeseeable acts of terrorism could send investors back into the trenches.

Even so, says Philip Dow, director of equity strategy at RBC Dain Rauscher in Minneapolis, "Everyone feels better this holiday season. When they check their brokerage statements and 401(k) at the end of the year, psychologically they're going to celebrate." And, in the coming weeks, investors will most likely do so by putting some money in the market.

Vickers covers the stock market for BusinessWeek in New York

Edited by Douglas Harbrecht

Before it's here, it's on the Bloomberg Terminal.