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Wall Street set for a Merry Christmas

The Fed rally was an unlikely, last-minute turnaround that only goes to show the strength of the seasonal effect.

LAST week, the stock market had one of its strongest two-day rallies of the last five years as the Federal Reserve told the bulls exactly what they wanted to hear.

This week, the gains are likely to continue as long as economic data validate growing evidence that US economic recovery is gaining strength and oil's newfound stability sticks.

"We are hereby declaring a holiday from rate hikes for several months," said Janet Yellen and her board - or that's what traders heard.

"The Fed didn't remove the punch bowl; they spiked the punch," said Sam Stovall, chief equity strategist at Standard & Poor's Capital IQ. "Akin to lighting the tree at Rockefeller Center, this response to the Fed's actions may have signalled the start of the Santa Claus rally."

Until the Fed's Christmas surprise, it appeared the stock bulls would get nothing but a lump of coal or, perhaps more appropriately, a pool of crude oil since the crash in oil prices had rippled through the stock market for much of December and had cut the broad Standard & Poor's 500 2014 gain almost in half by the low point midweek.

The Fed rally was an unlikely, last-minute turnaround that only goes to show the strength of the seasonal effect. Almost every year in recent times, the major indices finish at or near the highs of the year. It's almost as if a great magnet sits at the end of the annual calendar, drawing the S&P 500 and Dow Jones Industrial Average to their peaks no matter where they sit in mid-December.

There's a debate on Wall Street whether oil at US$60 a barrel is a positive or negative factor for the global economic outlook. The stock market was dragged down in part by fears that oil would cause the outright collapse of emerging-market currencies such as the Russian rouble, as happened in 1998.

Another danger was that small energy companies which had chased the oil boom by raising money on the junk-bond market would default on their debt and trigger another credit crunch.

In a wide-ranging report looking at the potential impact of lower oil prices, analysts and economists at Morgan Stanley concluded it was unlikely that oil's slide would cause a financial crisis either on the junk-bond market or in emerging markets.

"We would not expect a material pick-up in (junk-bond defaults) in 2015 as most companies have levers they can pull for the next year or two (for example hedges, borrowing flexibility, ability to reduce capex)," said analysts at brokerage Morgan Stanley, in a research note.

All agree - even Russian President Vladimir Putin - that nations dependent on oil exports such as Russia will suffer unless the oil price rebounds quickly. For oil importing nations, however, the drop in price should be a tonic for growth.

"We expect Russia to take a big hit to growth, and several Latin American economies (for example Brazil, Mexico) to also take a smaller growth hit," said the Morgan Stanley analysts.

"In Asia, Malaysia is similarly exposed. On the other side, Thailand and Indonesia, for example, should benefit significantly and several eastern European economies should also get a growth boost."

Analysts at investment manager T Rowe Price deem a repeat of the 1998 financial crisis unlikely.

"Most developing countries now have flexible exchange rates and monetary policies, ample foreign exchange reserves, and relatively low debt burdens, all of which should help prevent systemic contagion as seen in the late 1990s," said the T Rowe Price analysts, in a note on the firm's website.

It was the pace rather than the scale of the oil price decline that sent a shock to the financial system, said Prudential Financial. If prices continue to bounce between US$55 and US$60 a barrel as they did for much of last week, the stock market's attention may even turn to other things, such as economic data.

Before the oil bust, the US had regained its title as the world's economic superstar, a mantle it gave up to emerging markets as long ago as the 1960s. Every revision of gross domestic product growth seems to be an upward one. Economists expect another upgrade to third quarter growth this week, with the latest Commerce Department tally likely close to the 4.6 per cent level in the second quarter that everyone on Wall Street had reckoned unsustainable.

Similarly, the November durable goods orders is expected to be strong. Last week, used-car dealer CarMax reported another quarter of robust growth, confirming carmakers' reports of near-record sales in November. Used-home sales data may reveal whether the extension of low borrowing rates will spur demand for mortgages.

The main factors in the stock market's favour this week may be the technical ones. This is the time of the year that retirement accounts and mutual-fund managers traditionally load up on stocks. The Santa Claus effect has become self-reinforcing as short-term traders jump on for the sleigh ride. Statistically speaking, Christmas week is one of the most wonderful times of the year for the stock market.