What a Week: Rally Runs

Bulls appear to be banking heavily on fourth-quarter strength.
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The bulls are feeling giddy.

After all, they've seen three straight weeks of gains for the

Dow Jones Industrial Average

and the

S&P 500

and four consecutive for the

Nasdaq Composite

.

Plus, with bonus season for money managers just around the corner, the market's almost religious belief that stocks must go up in a traditional fourth-quarter rally is again proving to be a powerful ally.

The unfaithful, however, were still wondering whether the bounce from the October lows had run its course, given the uninspiring action during the first three sessions of the week. But a successful auction of 10-year Treasuries sparked another rally on Thursday and follow-through action on Friday.

On the last day of the week, the Dow gained 45.94 points, or 0.4%, to 10,686.04. The S&P advanced 3.76 points, or 0.3%, to 1234.72. The Nasdaq rose 5.79 points, or 0.3%, to 2202.47.

For the week, the Dow and the Nasdaq each climbed about 1.5%, while the S&P rose more than 1%. The gains follow last week's increases of 1.2% for the Dow, 1.8% for the S&P and 3.8% for the Nasdaq.

Interestingly, the American Association of Individual Investors weekly sentiment survey showed 58.6% of respondents were bullish even before Thursday's rally. That level of optimism has contrarian investors believing that much of the bounce from last month's lows has probably run its course.

So far, the Dow has rallied 4.6% from its Oct. 13 low of 10,216. The Nasdaq has rebounded an impressive 8.1% from 2037 on Oct. 12, and the S&P has gained 4.9% from its worst level of 1176 on Oct. 13. At 1234, the S&P is within reach of its 2005 high of just under 1246.

As proof of bullish resilience this week, the market had to digest

General Motors

(GM) - Get Report

sinking to a 23-year low after restating its earnings, along with disappointing guidance from

Dell

(DELL) - Get Report

and

Cisco

(CSCO) - Get Report

.

Perhaps the biggest shocker came Tuesday when

Toll Brothers

(TOL) - Get Report

cut its guidance for 2006 amid slowing demand and cooling prices for its homes.

Still, the fact that the broad market was saddled with only modest losses that day could be a testimony to the bulls' belief in the fourth-quarter rally.

As

mentioned here, the warning cuts much deeper than housing stocks, given that home equity extraction has provided critical fuel to U.S. economic growth over the past few years.

Right now, the market remains confident that its plunge to five-month lows in October has sufficiently discounted worries about post-Katrina inflation, a hawkish

Federal Reserve

and an overstretched consumer.

Bolstering that is the fact that energy prices have continued to decline amid unusually warm temperatures this fall. Crude oil futures finished the week at $57.53 per barrel and gasoline at $1.49 a gallon.

The mild weather might also help explain why October chain-store sales came in stronger than expected last week and why economists are upbeat about Tuesday's retail sales figure.

October sales are expected to drop 0.6%, after a 0.2% gain in September, according to a

Reuters

survey of economists. However, most of the predicted decline will be the result of a 15% plunge in auto sales. According to Lehman Brothers economist Drew Matus, core retail sales should have risen a solid 0.6% for October.

The stock market recent rally has been banking on such figures. A look at this month's leading sectors in the S&P 500 (as of Thursday's close) reveals as much. Consumer discretionary was the second-best performing sector, rising 1.7%. Information technology led the pack with a 2.5% gain for October so far.

The bullish market of the past three weeks may now be pricing in perfection. Just like the market may have been discounting all the negatives in October, now it's discounting the positives. However, the fact that it's doing it ahead of time -- the key holiday shopping season begins in earnest after Thanksgiving -- may make stocks more and more susceptible to a sell-the-news mentality.

Positive retail sales next week, which would provide fresh evidence of consumers' ability to withstand energy prices, may still be a positive catalyst for stocks. In addition, both the consumer and the producer price indices next week should reflect last month's drop in energy prices.

Of course, the market will eventually have to come to terms with the notion that consumption in the last stretch of 2005 may not be entirely rosy.

According to Lehman's Matus, the fourth-quarter shopping season got an early start, in part from the warmer weather but also because retailers have launched heavy promotional campaigns. Furthermore, "steep declines in auto sales at the start of the quarter and the persistent weakness in non-durables spending point to a measly 0.5% real gain in consumption

for the quarter," he says.

Market guru Woody Dorsey, the founder of Market Semiotics, says the current bounce in stock prices "has about run its course" and that "December is not bullish this year." The S&P, Dorsey maintains, won't surpass its 2005 high.

He may well be right. Should a cold snap revive energy prices, the market could be painfully reminded that winter heating bills are still going to be much higher than last year's. For consumers, the question then will be how long they're willing to stay the course.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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