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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."