Why the ASX’s big new year rally means nothing

For many investors, there’s no better way to start off a new year than to have a nice big share market rally. With good manufacturing news coming out of the U.S . and even some positive news coming out of Europe saw the S&P/ASX 200 index surge over 3 per cent higher in the first days of January trading.

Whilst that might make some punch-drunk investors happy, we have some cautionary words. If you believe that the big advance somehow predicts an automatically strong year for shares, think again — because the market has disappointed investors countless times in the past.

Many investors believe in seasonal cycles, and one of the most popular is the so-called January effect. Some even take it further, giving the January effect predictive power over the performance of shares throughout the year. Below, we’ll take a look at the possible justifications for a January effect and then look for evidence of whether it really exists.

What is the January effect?
As a seasonal indicator, the January effect has two primary components. The simplest is that shares tend to perform well during January overall, with a particular emphasis on the first few days of the month.

Combined with the Santa Claus rally in late December, the seasonal move helps support the longer-term semi-annual cycle that most people know as the “sell in May” indicator. With shares broadly performing better from November to April than from May to October, a boost early in the year is often an essential contribution to the returns for the winter half of the year.

Is the January effect real?
Some fundamental underpinnings exist for a why a January effect might occur. Late in December, some investors, particularly those in the U.S., scurry to sell their shares to lock in tax losses . By January, that opportunity is gone, so those who had been selling shares are no longer pushing prices down.

What a day!
The effect seemed to work great on the year’s first couple of trading days. Shares rose broadly, with gains pretty much across the board.

Moreover, some of the big gainers were the same shares that had dropped severely in previous weeks. Of the resources stocks, Karoon Gas (ASX: KAR), Fortescue Metals (ASX: FMG) and BHP Billiton (ASX: BHP) all had strong starts to 2012, yet all remain some way below their peaks of 2011. Even OneSteel Limited (ASX: OST), a company we’ve previously advised investors to run away from, joined in the party.

On the other hand, party poopers included beleaguered retailer  JB Hi-Fi (ASX: JBH) and fellow former high flyer, regenerative medicine company Mesoblast (ASX: MSB).

A dubious track record
The problem, though, is that the January effect doesn’t consistently make you money. Even after a promising first day or even week, shares often fall back.

When you own shares and the market goes up, it makes sense to celebrate. But don’t draw any grand conclusions about the January effect from a single day’s gains. All too often, they can evaporate before you know it.

In any event, paying too much attention to the overall market doesn’t make sense, because the right shares can beat it. We highlight our favourite idea for the year ahead in  The Motley Fool’s Top Stock For 2012. Don’t wait — get your free copy right now and start the year off right.

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