Wall Street Hoping All That Liquidity Won't Freeze

The prospect of New Year profit-taking has some market-watchers worried.
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For many portfolio managers, the best thing about kicking off 1999 will be that they're still around.

For a while there, it didn't look like that would be the case. When the market was mired in

Long Term Capital Management

-created muck this September, plenty of hedge-fund managers -- some of them real veterans -- were worrying they would have to close shop.

That officials were able to reverse the flight of capital and calm investors down was a pretty good trick. That the market was able to post its fourth year of double-digit gains was remarkable. Because of that performance, however, the first days of the year may be a bit rough despite the vast liquidity welling up in the market.

"It's quite possible there will be some capital gains getting nailed at the beginning of the year," said Rao Chalasani, chief investment strategist at

Everen Securities

. "The liquidity that will come into effect, whether it's because of bonuses or IRA accounts, will help the market through the course of January, though that may not be the case in the first few days."

Beginning-of-the-year profit-taking aside, the market looks like it could use a break. Since its mid-December low, the

S&P 500

has advanced nearly 8%. Yet funds saw outflows during that time, according to

AMG Data Services

. One of the reasons the market advanced anyway was that fund managers, anticipating the January flood, were taking cash off the sidelines and putting it into the market. So the market has at least partly discounted the expected rush of cash.

If anything looks ripe for profit-taking, it is the Internet sector. To use the most obvious example,

Amazon

(AMZN) - Get Report

gained 970% in 1998. For anyone whose held this stock for a while (and a "while" in Internet terms is about three months), the temptation to cash in some chips is high. And because the Internet sector have become something of a poster child for the incredible confidence investors have placed in the market, a drop in these stocks could cause a bit of anxiety.

"If you have a serious break in

AOL

(AOL)

, Amazon,

Yahoo!

(YHOO)

-- those companies that are being recognized as the true leaders -- that might have an effect on the broader market," said Chalasani. But as for the SouthSea.coms that have grabbed a lot of attention lately, Chalasani does not think that the market will bear any damage if they fall to earth. They are hot-money issues, he points out, and not widely held.

Plenty of people on Wall Street took the last couple of weeks off, and when they return they will need to figure out what to make of the selloff in Japanese government bonds. JGBs fell off the cliff last week after

Bank of Japan

Governor

Masaru Hayami

said the government would stop bond purchases in January. That was enough to send Japan's bond market, already worried about a spate of new supply, into a panic. The yield on the benchmark 10-year JGB ended the year at 2.01% -- its highest level since September 1997. In mid-November, the yield was at 0.83%. And nobody is really quite sure what that swift change means.

"It happened so swiftly and it happened in these thin days, so we haven't gotten the analytical commentary to really get a handle on this," said Bill Sullivan, chief money market economist at

Morgan Stanley Dean Witter

.

Once people get back into their offices on Monday, they'll be trying to handicap a couple of dangers. One is that the drop in the JGBs, and the attendant strengthening of the yen, could prompt the unwinding of carry trades, in which investors have borrowed in Japan to buy elsewhere. So far, shorter-term interest rates in Japan haven't risen dramatically, but there's a danger that they could. Should that happen, we could see funds getting pulled out of the U.S. bond and stock markets.

The other worry is what the selloff does to Japan's recovery prospects. Unlike their counterparts in the U.S., where many companies in need of cash go to the equity markets, Japanese companies rely heavily on borrowing for their capital needs. With borrowing costs rising, companies may be in for a rough time.

Besides watching the movement in JGBs, Treasury traders will be keeping a careful eye on the premiere of the euro. "We've got to see how that affects the market," said Sullivan. "There's a possibility some portfolio managers will be moving out from dollar-denominated to euro-denominated instruments. The footprint for that allocation change would clearly be the foreign-exchange arena."

And then there is the economy. The

Federal Reserve

will likely not cut rates again until it sees that this slowdown everyone has been talking about starts to show up in the economic data. The week kicks off with the

National Association of Purchasing Management

index on Monday. The December jobs report is on Friday.