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Nothing's nicer than a big rally to start off the new year. But before you take long-held market folklore about January advances to heart, take a step back and look closely at the actual evidence.
The January effect and you
Among seasonal factors, the January effect has a secure place in the folklore of the stock market. The idea is quite simple: According to proponents of the effect, stocks have a seasonal tendency to rise during January, especially the first week of the year. In conjunction with the popular concept of Santa Claus rallies, the January effect is a key positive component that contributes to seasonal outperformance from November to April, which is the other half of the more popular market-timing maxim, "Sell in May and go away."
There are several theories for why a January effect might actually exist. Some argue that investors sell stocks toward the end of the year for tax purposes, and then have to wait until January to buy those stocks back. Another possibility is that those who max out their contributions to IRAs and 401(k) plans early in the previous year can suddenly add to their retirement accounts each Jan. 1, boosting interest in stocks.
One day proves nothing
At least on Monday, the January effect seemed to be in full force. Stocks opened strong, with major market indexes making big gains to multi-year highs.
Interestingly, some of the biggest gainers were stocks that were following through on strength from late 2010. Molycorp (NYSE: MCP ) and Rare Element Resources (AMEX: REE ) both jumped sharply after China curtailed exports of rare earth metals, putting these potential producers in an even bigger spotlight and adding to their share gains in recent months. Office Depot (NYSE: ODP ) and Sprint Nextel (NYSE: S ) also saw buying interest, as value investors apparently believe the struggling stocks may finally be poised for a longer-term recovery -- or a buyout bid.
Even financial stocks joined in the feeding frenzy. Bank of America (NYSE: BAC ) added to big gains since November in light of its settlement with Fannie Mae and Freddie Mac on allegedly problematic mortgage loans. The settlement helped boost not only B of A and industry peers MBIA (NYSE: MBI ) and PMI Group (NYSE: PMI ) but also the overall market.
But you can't count on the January effect to provide big profits every year. Even after a promising first day of trading, the markets haven't always cooperated with investors.
For instance, the stock market has risen on the first trading day of the year for each of the past three years now. Yet in 2009 and 2010, stocks disappointed investors by the end of the month. In 2009, the S&P 500 went up more than 3% on Jan. 2, prompting hopes that investors had already weathered the worst of the financial crisis. But by the end of the month, the large-cap index had dropped more than 8%, setting the stage for March's selling climax.
The following year, the mood was much different. A yearlong rally from the March lows had brought many investors back from the brink of ruin, but many were concerned that those gains could prove to be short-lived. The S&P rose more than 1.5% on the first trading day of January, but the index couldn't hold those gains throughout the month, and the market eventually fell just under 4% by Jan. 31.
Don't throw the dice
As many investors discovered last September when the historically weak month produced huge gains, counting on seasonality to pay off for your portfolio can drive you crazy. What seems to be a tried-and-true, dependable trend can suddenly stop working -- throwing your investments for a loop. In general, you're much better off trying to figure out what fundamental factors will affect your stocks and then invest accordingly.
So even if yesterday's rally has you smiling, don't get cocky. Stocks are no more a sure thing during this month than ever, and if you don't realize that, you might be setting yourself up for a big fall.