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WALL STREET INSIGHT

Stock market rally set to continue but all eyes on bitcoin

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Some stock investors are watching the violent rally in bitcoin and anticipating an equally violent selloff. That could cause spillover effects for broader markets.

US stocks finished around record highs again last week as a strong jobs report and the prospects of tax cuts suggested economic growth - and stock market gains - will continue to accelerate.

The economy added 228,000 jobs in November, more than economists had expected, as rebuilding of Houston and Florida in the wake of major hurricanes led to an increase in construction jobs, according to analysts at brokerage Bank of America Merrill Lynch Global Research.

With the Dow Jones Industrial Average up by almost 25 per cent for 2017, this is one of the biggest stock market rallies of the current cycle. The rally is almost certain to continue this week, fuelled by seasonal bias and the likely outcome of a central bank meeting. The Federal Reserve is expected to raise interest rates for the first time since June and that will likely push shares of banks, among the leaders of the Dow's rally, higher still.

Yet, for the first time since the 2007 housing boom, the stock market will not lead the business news this week. For the gains in the Dow Jones Industrial Average are petty compared with those in "cryptocurrency" bitcoin. And this is the week when bitcoin futures start to trade on major exchanges such as the Chicago Board Options Exchange (CBOE).

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Most bull markets end with a period of speculative hysteria and seldom has there been a more hysterical bout of speculation than the recent bitcoin rush. Each bitcoin is a chain of numbers whose value is recognised because they are linked to transactions recorded on an open-access ledger known as the blockchain.

In the last couple of weeks, gains in the price of bitcoin have gone from eye-catching to practically unprecedented. That's because of a belief that the investment floodgates are about to open. Bitcoin has, to date, been tricky for most investors to buy. The websites that trade the digital currency itself are relatively new and unregulated. There are several exchange-traded products that track the price of bitcoin, but none of them trade on a major US exchange. That's about to change this week.

"Demand is massive in anticipation of futures," said Lorenzo Di Mattia, manager of hedge fund Sibilla Global Fund. "This is going to become the biggest bubble in history...today cryptos (are valued) at about US$430 billion market cap."

Mr Di Mattia noted that bitcoin prices roughly doubled every month this year. Last week, on its way to its current level at around US$16,000, bitcoin managed to double in price in the space of about five days.

Some stock investors are watching the violent rally in bitcoin and anticipating an equally violent selloff. That could cause spillover effects for broader markets. If, for example, a massive selloff in bitcoin causes a margin call and investors are over-extended, futures exchanges such as the CBOE, which are a key part of the US stock and commodities markets, could run into trouble.

It's that kind of "contagion" that Thomas Peterffy, the founder of electronic-trading pioneer Interactive Brokers, has warned could spread from cryptocurrency markets and cause a financial crisis.

One brokerage has warned for some time that the acceleration of gains in the most expensive areas of the US stock market - including cryptocurrency-linked stocks such as Nvidia - is a sign of the bull market's age. This week's Fed rate hike could be the beginning of the end, they warn.

"Investors are chasing growth and high-yielding assets in a bull market that's been driven and enabled by central bank liquidity," said analysts at BofA Merrill Lynch, in a note to clients. "We see an end to this Icarus trade and an aggressive downgrade of risk assets once profits peak, investor positioning becomes excessively enthusiastic and central banks start withdrawing liquidity as they scale back support."

One thing that could extend the bull market's life are the Republican tax cuts, which promise to be the biggest change to individual and corporate rates since Ronald Reagan's overhaul of tax laws in the 1980s. Corporations with US headquarters could see their base rate reduced to 20 per cent from 35 per cent. Most individual Americans will see a reduction in payments, at least initially, although these cuts will likely be offset by the removal of certain tax credits.

"Estimates vary and are dependent on what corporate rate ends up in the final bill, but the collective earnings of S&P 500 companies could improve by around 5-15 per cent versus profits at current rates. This would have the effect of making valuations seem more palatable for investors," said portfolio managers at Texas money manager Alpha Capital Management.

For now, bitcoin and stock speculators are popping champagne corks. But the hangover will set in eventually.

READ MORE: Mixed reactions to launch of bitcoin futures