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A Wild Week for Wall Street?

A Wild Week for Wall Street?

The week between Christmas and New Year tends to be a little wild on Wall Street. For one thing, trading volumes are thin, and some portfolio managers are looking to shuffle their holdings one last time before the year ends—and the combination may have an exaggerated impact on any stock movement, up or down. Also, many senior traders are on vacation, leaving more risk-averse junior employees in charge. This year isn't likely to be much different, even if Washington did take away some of the motivation to game taxes when it settled the income tax and capital gains picture for 2011 and 2012.

Historically, the stock market has ended the year on an up note more often than not—the so-called Santa Claus rally. Since 1928, the Standard & Poor's 500 index has had a positive return 74.7 percent of the time during the last week of the year, with an average gain of 0.74 percent, according to Bespoke Investment Group, a money management and financial research firm in New York's Westchester County. And in years when the S&P 500 Index has risen more than 10 percent, an average gain of 1.1 percent has come in the last week of trading, Bespoke says. As of Dec. 22, the index was up 12.9 percent for 2010.

The last week of the year also tends to show more stock swings than usual. The Chicago Board Options Exchange Volatility Index, or VIX, has been higher in the last week than during the first week of December in 11 years out of 20. This December, the volatility index averaged 17.65 through Dec. 22. Over the past 20 years, the VIX has averaged 19.85 during the last week of the year.

Spooky Omens

With the S&P 500 trading at two-year highs this year and overbought in the eyes of some strategists, concerns about a last-minute selloff may hold more weight.

"It's not a good time to make big decisions," such as a once-a-year reallocation of assets within your portfolio, says Art Hogan, chief market analyst at Jefferies & Co. in Boston. Still, many people wait until yearend to take profits or harvest tax losses, and that procrastination can cost them if the trades are big enough. "If you're long a loser, you probably have some company, and you're probably not the only person looking at this as a tax-loss candidate," Hogan says. "If you wait till next week to get that done, you're going to run into low volume."

Bill Stone, chief investment strategist at PNC Wealth Management (PNC) in Philadelphia, suspects there won't be as much need for tax-loss selling given the market-wide gains in 2010. And now that the uncertainty around taxation is off the table, he says he doesn't expect the same kind of pressure to exit positions and take capital gains as he would if doubt persisted about next year's tax rates.

Barry Ritholtz, chief executive and director of equity research at FusionIQ and the creator of The Big Picture market blog, doesn't believe clarity about how investments will be taxed for the next two years will reduce volatility during holiday trading. He says nothing is worse than certainty for the market, because it deprives investors of opportunities.

When Volume Ebbs

Having Christmas fall on a Saturday this year might reduce the chances of a drop in liquidity, compared with when the holiday comes in the middle of the week. When the markets are open on Dec. 26, trading volume is generally about 20 percent of the daily average. This year, a full work week after the holiday means volume probably won't be below 50 percent of the daily average, Hogan says.

Leaving junior trading staffers to mind the store while their more experienced bosses are on vacation adds to some investors' worries. But Hogan says the spike in volatility is "more a function of the overall number of players in the market than it is the junior varsity team being on the field." Still, PNC's Stone says that since junior employees want to avoid mistakes and "tend to not want to stick their necks out as much as their senior counterparts," bid-ask spreads will probably widen during the week before New Year's, especially on over-the-counter platforms.

As during normal trading weeks, economic and geopolitical news could lead to some wild stock swings. The European sovereign debt issue that keeps coming into and out of focus for investors, or a resurgence in tensions between North and South Korea, would be market-moving events. "It's not predictable when the next disaster du jour is going to occur. Anything that acts as a catalyst will have more fuel behind it in an overall low-volume environment," says Hogan.

High—But Not Too High

Cleveland Rueckert, an equity strategist at Birinhyi Associates, a market research and money management firm in New Haven, says all S&P 500 sectors except utilities are currently overbought. But since none of the sectors is priced at an extreme high by historical standards, there's no certainty of a holiday selloff. Given the 15 percent drop that occurred just six months ago, Rueckert doesn't expect a major market pullback soon. At the close of trading on Dec. 22, the S&P 500 Index was up 23.1 percent from its July 2 low. He expects stocks to make further gains in 2011 and has a price target for the S&P 500 of 1,333 at the end of next year.

Ritholtz at FusionIQ agrees that market sentiment is "a little frothy" right now, aided by some rotation out of bonds into equities. While he projects a pullback of 5 percent to 10 percent within the next two to three months, he sees no signs that the rally that began in March 2009 is over yet. The day of reckoning for equities, he believes, may come when it's time to raise the federal debt ceiling. Total public debt outstanding stood at $13.87 trillion on Dec. 21 and is expected to reach the current legal limit of $14.3 trillion within the next few months. A vote against raising the debt limit could signal to the market that the government isn't confident it can meet debt obligations, which could trigger a selloff, some analysts say.

However bumpy trading may get next week, it's important to keep in mind that the market doesn't move on companies' business fundamentals during the holiday period, says Paul Brigandi, a senior portfolio manager at Direxion Funds. And Ritholtz adds that while stock valuations may wobble more than usual while traders are away, they'll revert to their previous patterns after the pros return to work.