By Angela Moon
NEW YORK (Reuters) - Wall Street will see the year-end rally carry into the last week of 2010, but the question on everyone's mind is, "what's next?"
The Dow, the S&P and the Nasdaq on Thursday were up more than 5 percent on the month, and the level of optimism in the market was at a six-year high. The CBOE Volatility Index VIX <.VIX>, known as Wall Street's fear gauge, was down by two-thirds from this year's peak in May.
"I would think that the Santa Claus rally will continue into next week as there are still lots of mutual funds trying to beat or at least meet the performance of the S&P 500 within the calendar year of 2010," said TD Ameritrade's chief derivatives strategist, Joe Kinahan, who is based in Chicago.
"The VIX is also telling us that the market is expecting low volatility, which would also support upside movement."
China's Christmas day rate increase could spoil the party early in the week as the mammoth economy grapples with inflation, threatening to dent global trade. The rate rise was widely expected, though its exact timing came as a surprise. Illiquid markets next week could exaggerate any sell-off.
Some contrarian analysts were also more cautious as optimism at peak levels is usually a sign of a pullback and thus, negative for equities.
"We are continuing to make new highs as volume tails off, and the question is -- will it lead to some potential weakness into early next year?" said Ryan Detrick, senior technical strategist at Schaeffer's Investment Research in Cincinnati, Ohio.
"We think there could be a correction of 5 to 7 percent" toward the second half of January, he said.
BULLS IN CHARGE
According to the latest AAII Sentiment Survey, the level of optimism in the market rose 13.1 percentage points to 63.3 percent in the week ending December 22, the highest since November 18, 2004.
The level of pessimism was at the lowest since November 24, 2005, and the bull-bear spread was at the highest since April 15, 2004.
The AAII Sentiment Survey measures the percentage of investors who are bullish, bearish and neutral on stock market for the next six months.
Investor's Intelligence report, another indicator for market sentiment, showed 58.8 percent bulls for the week of December 17, the most bulls since the S&P 500 peaked in October 2007, when 62 percent of the respondents were bullish.
"Currently, bullish sentiment has been rising, but we feel optimism is not widespread and only skin deep, which means that investors are likely to turn bearish at the first downtick," said Bruce Bittles, chief investment strategist at Robert W. Baird.
"If bullish sentiment persists into late January, it would become more worrisome."
U.S. stocks racked up a fourth straight week of gains on Thursday, as investors expected optimism about the economic recovery to support equities through year-end.
For the week, the Dow <.DJI> was up 0.7 percent, the S&P 500 <.SPX> was up 1 percent and the Nasdaq <.IXIC> was up 0.9 percent.
For the month, the Dow rose 5.2 percent, the S&P rose 6.5 percent and the Nasdaq rose 6.7 percent.
For the year, the Dow gained 11 percent, the S&P gained 12.7 percent and Nasdaq gained 17.5 percent.
All three indexes were above levels reached on Sept 12, 2008, the last trading day before the collapse of Lehman Brothers at the height of the financial crisis.
"Momentum is overbought on most time frames, hinting of a lurking pullback," said BBH Equity Research in a note to clients.
The VIX, which closed at 16.47 on Thursday, was down 64 percent from this year's peak of 45.79 in May.
The index, which usually moves inversely to the S&P 500 benchmark, was down 24 percent since the beginning of the year.
But VIX futures were suggesting the index is expected to move up to 21.55 by February and 23.20 by March.
"Odds are that a meaningful correction lies in the near future, said Larry McMillan, president of McMillan Analysis Corp in a report. "If it occurs next week (which would be typically contrary, because pretty much everyone has already written next week off as another one of steady gains, just like this one has been), then that could actually generate a major sell signal."
Economic data due next week include the S&P Case-Shiller home price index and Consumer Confidence data on Tuesday and jobless claims and pending home sales on Thursday.
(Reporting by Angela Moon; Additional Reporting by Doris Frankel in Chicago and Rodrigo Campos in New York; Editing by Leslie Adler and Gunna Dickson)