SPY Likely to Surpass $126 Today

| About: SPDR S&P (SPY)

We envision that Tuesday will be a strong day in terms of upward price movements, driven by three key macro variables: The drop in the dollar index spot price; strong retail sales; and the momentum gained after the market shrugged off China’s surprise increase in interest rates on Christmas Day. Between the snow on the east coast and traders taking extra time off between Christmas and New Year's, volumes were extremely light; only 58.13 million shares of SPY were traded, down -66% from the average 3-month daily volume of 171.84 million shares.

Now let’s look at the three drivers, which we project will drive the S&P 500 (and SPY) higher on Tuesday:

Last night, as of 1AM EST, the dollar index was down sharply by -0.467 to 79.875. Taken in isolation, we’ve shown that the dollar index has a high inverse correlation with the level of the S & P 500 Index.

The retail holiday season runs Nov. 1-Dec. 31. Heading into this week, the National Retail Federation predicted spending this holiday season would reach $451.5 billion, up 3.3% over last year. However, most of us were able to see that sales this year were definitely, significantly more robust than this prediction. Yesterday, reports confirmed this: U.S. retailers’ 2010 holiday sales, excluding autos, turned in the best results in five years by jumping 5.5% to $584 billion from Nov. 5-Dec. 24. This is up from last year’s 4.1% gain. From Oct. 31-Dec. 23, about $36 billion had been spent online, a 15% increase over last year.

In doing some of our own investigations, we found that the shopping malls were jam-packed throughout the U.S. except on the east coast, which was hammered by blizzards. The bull market of retail, we believe, is being driven by frugality fatigue, massive sales, and improved consumer confidence. After the holidays, the impacts of the first two factors will rapidly diminish, and we’ll be left with only improved consumer confidence driving spending.

The impact of the storms will be tricky to factor in to stock prices; we see this increased spending behavior as solidly correlated with the consumer sentiment index, which will be released Tuesday morning. We believe that consumer sentiment will come in at the highest point for at least the past 12 months, which will drive SPY over $126 for the first time in two years.

But, in terms of a reality check, around 15% of retail sales typically occur between Dec. 26-31. The blizzards on the east coast will definitely cut into these numbers. When the results are released in January, they may be a bit disappointing, which could result in a short-term hit to the S & P 500.

As consumers drive approximately 70% of our GDP, the boost in retail purchases this holiday season should set the stage for improved GDP growth in 2010 -- though not nearly enough to move the needle much in the way of reducing the unemployment rate. Increased retail sales will have a trickle effect up and down the value chain, from benefiting semiconductor companies to trucking companies who deliver the products to end customers and retail stores.

Given that much of the increased demand may be attributable to frugality fatigue, we don’t expect 2011 retail sales to be up by this same percentage over 2010 sales. We envision that after the post-holiday sales are over, however, Americans will re-group, work to pay down their credit cards and throttle way back on their spending. We estimate that 2011 retail sales will be up over 2010 -- but, most likely not by 5.5 percent.

When the post-holiday euphoria wears off, we don’t expect too much retrenchment in the market. Quite the opposite. The so called “January Effect” could contribute to driving markets even higher by the end of January.

Looking out to a further time-horizon (e.g. three months to one year), another macro element comes into play, which we haven’t discussed yet: The influx of European investors into S&P 500 stocks. As bailouts occurred in Greece and Ireland, the value of the euro devalued against the dollar by 8.4% in 2010. Adding this to the 13% gain we’ve seen in the S&P 500 Index, European investors would have enjoyed around a 21% gain year-to-date if they'd converted back to euros. As the euro could further devalue in 2011, investing in S&P 500 stocks or in SPY looks like an attractive investment opportunity from a European perspective. This could be yet another element driving the S&P higher in 2011; as discussed in earlier blogs, we see SPY rising to around $140 by the end of 2011.

Regarding China's rate hike: The People's Bank of China raised its benchmark interest rates by a quarter of a percentage point on Christmas Day, increasing its one-year lending rate to 5.81% and the one-year deposit rate to 2.75 percent. We’ve shown in the past that interest rate increases of this level cause over-reactions in the markets, which quickly are compensated for. This is what we saw on Monday. SPY and SPX both started off low, but over the course of the day prices continued higher. We envision prices to continue to rise for a good part of Tuesday as well.

Disclosure: I am long SPY.