Is this market rally legit or nothing but a head fake?

The few people left on Wall Street in the coming week will likely debate whether the stock market is on a course to new highs, or just in the final stages of a head fake rally that will end in pain when September rolls around.

During the summer doldrums, stocks have continued to move steadily higher, befuddling traders and analysts, who still see Europe lurking in the background as they worry about the US economy, the election and the “fiscal cliff.”

“It’s like a late December move,” said James Paulsen, chief investment strategist at Wells Capital Management. “Do you really put much credence in it? If everyone comes back in the first few weeks of September and this thing continues, then more people get on board. I think a lot of people think when the players get back, this thing is going to reverse.”

In the coming week, there are a few important reports including housing data and durable goods. There are also a few big earnings, including Hewlett-Packard.

Stocks ended the past week with gains, including in the Russell 2000 small cap index and the Dow Transports, two indices that had been lagging and both up more than 2%. The S&P 500 rose 0.9% to 1418, just below its April high of 1419, a four-year high. The S&P is now up nearly 12% since early June. The Dow, up 10% since June, was up a half percent in the past week to 13,275. The Nasdaq had the best gain in the past week after the Russell and Transports, rising 1.8% to 3076.

The stock market’s gains since June came amid signs of a slowing economy, dented by a lack of confidence and hit by a slowdown in Europe and elsewhere. But lately, the U.S. economic news has outpaced the substantially lowered expectations of economists, and analysts are monitoring the widely-watched Citigroup economic surprise index to see if it will continue to move higher.

The surprise index measures the actual data against economists’ expectations, and some of the data has beaten forecasts, including the July employment report and last week’s July retail sales. Just Friday, consumer sentiment improved, rising to a three-month high and leading economic indicators also topped forecasts, rising 0.4 percent, after June’s 0.4 percent decline. While it still shows sluggish growth ahead, the improvement in leading indicators was due to a drop in jobless claims and the surprise jump in housing permits.

Paulsen said while increasingly disappointing manufacturing data has been a source of concern, the surprise index is generally consistent with what happens in the market. “If nothing else, it’s a leading confirming signal,” he said, adding its recent choppiness will probably reverse when the latest data is factored in.

The past week has also seen a return to a higher interest-rate environment, as Treasury yields continued to climb off the record lows set last month when markets were gripped by fear about Europe’s debt crisis. The better data helped send the 10-year yield as high as 1.88, just above its 200-day moving average. By late Friday, it was yielding 1.817%.

With little to rouse markets, traders will be watching how yields continue to perform. This past week, speculation circulated that the improving data could keep the Federal Reserve sidelined at its September meeting, and forecasts cropped up that pushed much anticipated Fed easing back into the end of the year, or not at all. The Fed has been expected to conduct another round of quantitative easing, or the purchase of Treasurys or mortgage securities, in an effort to keep rates low and push investors into riskier investments.

The speculation the Fed will now hold off makes Wednesday’s release of minutes of the Fed’s last meeting important, even though the meeting occurred before improvement in the employment data, retail sales and housing reports. “These minutes will reflect the dovish statements, not the data we received that has mitigated against it. One could interpret the minutes as dovish. I hope people will see through it,” said David Ader, chief Treasury strategist at CRT Capital.

Ader said yields, off their week highs Friday, may have found the top of their range for now. “The 30-year came within breathing distance of 3%,” he said.

As for the coming week, anything from Europe could be important but the market itself may become the story. “Price action sometimes is the news,” said Ader.

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