Short-term concerns about the current "Santa Rally"

As the year draws to an end I thought it might be interesting to check in with Bernie Schaeffer, my boss, to get his thoughts on the short-term outlook. I asked him about his near-term outlook and he had three concerns about the action during the next few weeks.

The first concern is based on the level of optimistic comments being made by analysts. Tracking this form of "anecdotal sentiment" is time consuming as it requires constantly staying abreast of what is being discussed, but it offers a look into the mindset of the Street. When the expectations get one-sided, it can be warning sign to watch out for potential disappointments.

The second point of concern comes from the options market. Among other uses, options give investors a way to speculate and hedge. Monitoring the activity can give another perspective on what market players are feeling and expecting. The current data reveal a slant toward optimism as speculators have a preference for calls in some indices. Comparing the relative pricing of call options to put options also suggests optimism, as we have seen a contraction in the typical negative volatility skew we track.

His last point of concern is based on underlying deterioration in the small-cap area. The Russell 2000 Index (RUT) has turned lower after pushing to the 800 level, but most of the attention has been on the narrowly focused strength in blue-chip stocks.

Taken as a whole, it seems that expectations may have gotten a bit ahead of themselves, which opens up the possibility of some short-term volatility. However, Bernie is quick to point out that he is quite bullish about the overall outlook for next year. In BusinessWeek's poll of 80 strategists, Bernie maintains the highest year-end target for the Dow Jones Industrial Average. Calling for a new all-time high in the average, he does expect the economy will slow down next year, but believes that is already factored into expectations.

Nick Perry is an analyst with Schaeffer's Investment Research.