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market outlook

We have begun the Santa Claus trading season, that short window at the end of December and first couple of days in the New Year when stocks are expected to rise. The rule of thumb is that markets gain about 2 per cent on average during this festive period.

In other years, that might be all that one need say about market sentiment for the week. But this year everything seems so much more complicated.

Economic data has been largely positive enough to persuade most economists and strategists that the recovery is taking hold. This week they expect positive GDP news from both the U.S. and Canada. But sovereign debt trouble, a lack of improvement in the job picture and shenanigans among the U.S. banks are leaving investors uncomfortable.

So while investment firms forecast stable gains in 2010, major institutions are actually reducing their holdings of equities and bonds.

Bill Gross, for example, who manages the world's biggest bond fund at Pacific Investment Management Co., has just cut his holdings of government debt and raised his cash.

Strategists at Franklin Templeton Managed Investment Solutions met last week and decided to "ratchet down" their funds' exposure to risk. They reduced their position in stocks to 62 per cent, down from a high of about 70 per cent in the summer.

Economic data and accommodative monetary and fiscal policy continue to look positive, but several technical signs suggest the market has reached a peak, says Paul Vaillancourt, director of portfolio strategy at Franklin.

One of these "very bearish signs" is an indicator that measures sentiment and points to high spending and overconfidence among consumers and businesses. Both groups are taking advantage of low lending rates without sufficient attention to the longer-term carrying costs.

Other signals include thin trading volumes and the fact that many stocks are above their nine-month moving price averages, which suggest a reversal looms.

Throw in the rising U.S. currency, which Mr. Vaillancourt says has been oversold, and the markets' clear fragility and vulnerability to negative news, and there's good reason to step carefully in this market. It's not that strategists expect a sudden selloff, but stocks are struggling to break out of a tight range, and the most likely thing that could power them above it is real revenue growth this quarter. But that news isn't in Santa's sack.

"The rally has been pretty ferocious," Mr. Vaillancourt says. "People talk of a Santa Claus rally, but I think Christmas came early this year."

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STOCKS

North American stock markets could get off to a shaky start in the first half of 2010, but over all, Canaccord Capital Inc. predicts investors potentially could see double-digit gains, said Peter Misek, director of research, Canada, for Canaccord Financial Inc. "Waiting for the correction in our view would be a mistake."

The Economic Cycle Research Institute index, which comprises seven key U.S. economic factors, "has not recovered to the levels consistent with strong economic growth ... [but]we believe the index will continue to rise, albeit at a slower pace," he said.

The first half of 2010 could be hurt by investors beginning to anticipate rate hikes by the U.S. Federal Reserve Board, Mr. Misek said. But then he expects investors will begin to adopt a view that the economic recovery is stronger and broader than most currently think.

Canaccord forecasts the S&P/TSX could increase 7 per cent to 15 per cent, the Dow Jones industrial index 10 per cent, the S&P 500 8 per cent and the Nasdaq 12 per cent to 18 per cent.

CURRENCIES

The present four-week rally in the U.S. dollar is likely only a temporary reprieve from its downward move, said Camilla Sutton, a currency strategist with Scotia Capital Inc. There has been a change in sentiment in favour of the greenback and against other currencies such as the euro.

Three reasons account for the recent strength in the greenback - the better-than-expected U.S. economic data; an increase in sovereign risk caused by debt problems in Dubai and Greece, along with the nationalization of a bank in Austria; and increased awareness of euro zone problems. In part, the recent rally in the dollar reflects a bout of short-covering, Ms. Sutton said.

As a result of year-end portfolio shuffling, almost anything can happen in the next few weeks as currency traders establish trades for 2010, she said. "Our view is that the U.S. dollar is still in the midst of a long-term decline."

The 2012 U.S. elections suggest that it will be unlikely that the government will impose spending cuts or raise taxes, thereby postponing the hard decisions that need to be made to strengthen the U.S. dollar, she said.

COMMODITIES



The U.S. thermal coal market could recover a significant portion of the market share it lost during the recession in the power generating industry by 2011, said Bart Melek, global commodity strategist for BMO Nesbitt Burns Inc. in a report to clients.

The price of coal is likely to increase as a result of a rise in natural gas prices, additions to coal-fired power generating capacity, reduced mine output and improved demand for electricity with the economic upturn, he said.

BMO Nesbitt Burns projects Nymex Central Appalachia thermal coal to average $53 (U.S.) a ton in 2010 and $59.80 in 2011. "Long-term prices are projected to be $62 a ton, which BMO calculates is a level required to sustain the industry," Mr. Melek said.

A 56-per-cent drop in average natural gas prices during 2009 probably resulted in a 10.2-per-cent drop in coal-based generation, he estimated. "The dramatic shift away from coal into natural gas generation has left base-load coal facilities considerably underutilized for now."

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