Retail sales have continued to improve. Consumers' urge to buy something in the stores before Christmas must have been infectious because traders continued to lift stocks higher. The major U.S. averages are setting at new two-year highs and we've only got five trading days left for the year 2010. The S&P 500 index is up five weeks in a row and stocks are arguably short-term overbought. They're likely to stay overbought as investors wait for the calendar to roll over before locking in gains and incurring any new taxes.

One of the most bullish bits of news last week was the report on retail sales, which showed an improvement of +5.5% last weekend compared to a year ago. Store traffic is up. Sales are up. Consumers must be feeling a lot more optimistic in spite of our 10% unemployment. You've heard it a hundred times. Many believe that consumer spending powers 70% of the U.S. economy. Any news item that talks about improvement in retail sales should be positive for the stock market.

The U.S. dollar has been a major headline for the last couple of years. This is unlikely to change in 2011. While the Federal Reserve's QE2 program should keep the dollar weak the currency is still competing against the yen and euro, which have their own problems. Dollar weakness is normally bullish for commodities and vice versa. The bounce in the dollar this past week should have been bearish for commodities. Yet crude oil has rallied over $90 a barrel and people are talking about oil at $100 again. This news is having a negative impact on the airline stocks.

We have been warning readers for weeks that China might raise its interest rates. Investors have been worried that if China raises rates the slowdown in its economy will ripple throughout the entire globe and what if they go too far? This Saturday China did raise rates by 25 basis points to 5.81%. The question now is how will the world markets respond? Traders have been expecting this for so long now should anyone really be surprised? China needs to do something to combat the country's rising inflation. Stocks could see a move lower on this move come Monday but I would expect any sell-off to be short lived. Keep an eye on the Asian and European markets Monday morning to get a feel for what the U.S. markets might do.

Looking ahead at the economic calendar this week we do have a few noteworthy events but I'm not sure anyone will be paying attention. Volume is very light during the last week of the year, but then again sometimes super light volume can allow big moves to occur. This Tuesday we'll hear the latest Consumer Confidence reading for December. Plus the 20-city Case-Shiller home price index. Thursday will bring the weekly initial jobless claims and economists are expecting a drop toward 403,000 new unemployment claims. Thursday will also see the Chicago PMI data for December and pending home sales figures from November.

Looking at the major averages you could easily argue that stocks are overbought. The S&P 500 has delivered a very impressive December move. There really isn't a lot of significant overhead resistance until the 1300 area. The rally will probably just run out of gas instead of reversing at any clearly defined obstacle. On a short-term basis the S&P 500 should see some support near 1245 and the 1225 areas. When we actually see a correction the move will be a lot more exciting. A -5% pull back from current levels would be a dip toward 1,193. A -10% correction would be a drop toward the 1,130 level, which I consider to be pretty unlikely. I would focus on support near 1200 or the 1175 area. The time frame for any correction is the tricky part. More on that in a minute.

Daily chart of the S&P 500 index:

Weekly chart of the S&P 500 index:

Not much has changed for the NASDAQ Composite. The index is nearing new three-year highs. It remains short-term overbought but there isn't a lot of overhead resistance until it hits the 2725 area. I would expect some resistance near the 2700 level just because traders like to focus on big round numbers. When stocks correct, and they will, it could be painful in the NASDAQ. A normal -5% correction from current levels would be a dip to 2531. A -10% correction would be a decline near the 2400 area, which I'm certainly not expecting. Technically the NASDAQ composite has found support near its rising 40-dma back in November so keep an eye on it as an extra indicator to watch.

Daily chart of the NASDAQ Composite index:

Readers know I like to keep an eye on the SOX semiconductor index. Currently it remains inside its narrow bullish channel. A breakdown could be an early warning sign for the tech-heavy NASDAQ.

Weekly chart of the SOX semiconductor index:

Small cap stocks continue to perform very well. The Russell 2000 index ($RUT) has advanced through several layers of key resistance. The next level of potential resistance is the 800 mark. On a short-term basis broken resistance at 780 is new support. Yet a normal -5% correction would see a drop toward the 750 area. A -5% pull back from the 800 level would be the 760 level. Odds are the $RUT will see more volatility than its big gap peers. We may want to watch for a -7% or -10% correction in early 2011.

Daily chart of the Russell 2000 index:

Weekly chart of the Russell 2000 index:

Big picture, nothing has changed from my comments a week ago. Stocks are trending higher. Unless some news event occurs this trend should continue. The rise in Chinese interest rates could be an excuse to sell but then when stocks want to go down they always find an excuse. Right now it seems that investors are just happy to sit on their positions until the year ends. When January arrives it will bring with it a new round of inflows into funds who will put that money to work in stocks. Thus the first few trading days of January should have a bullish bias. It's the middle and later half of January I'm worried about.

Earlier I said the tricky party was timing for the correction. January provides a new year for investors to sell and worry about the tax implications a year down the road. Plus, the fourth quarter earnings season will being in mid January and earnings always provide a convenient opportunity to sell the news and lock in gains. Analysts will be keenly focused on corporate America's guidance for 2011. If management disappoints then stocks will naturally tend to fall as people readjust their expectations and valuations. I am expecting a pull back in the middle to second half of January. The correction could last a good two or three weeks but traders might start jumping in once we see a -5% decline.

On a positive note the bond market bubble appears to have burst. With the Fed focused on their QE2 program it should keep bonds unattractive and drive cash into the stock market. At the same time the QE2 program should be bearish for the dollar, which is bullish for commodities.

Our outlook for 2011 is bullish but we want to wait for a correction in January or February before launching any new bullish positions of significant size.

- James