January has been a month of superlatives – positive and negative.
Here are the positive:
The S&P 500 was up 4.36% in January 2012, the biggest January gain since 1997.
For the entire month of January, the S&P 500 never suffered any more than a 0.6% drop. This is the first time ever.
Unemployment, at least the official number, dropped to 8.3%.
Here are the negative:
Trading volume has been abysmal. You may remember me harping about low volume last year at this time. Well, the average number of daily NYSE volume last year was 891 million shares. This year it was 661 million shares, a 26% drop. As point of reference, in 2008 an average of 1.12 billion shares were traded every day in January, 59% more than this year.
The state of California is out of cash again (sooner than expected) and may not be able to pay for tax refunds.
The debt-to-GDP ratio for the United States is now north of 100%.
U.S. home prices dropped another 3.7% nationwide based on the most recent S&P Case/Shiller Home Price Index.
The stock market’s January performance raised two obvious questions:
1) Why are stocks rallying that hard?
2) Will they continue to rally?
Why Are Stocks Rallying so Hard?
Doesn’t 2012 thus far feel much like 2011? It does for a number of reasons. The Fed was pumping cash into the market via QE2 in 2011 and the Fed is once again pumping cash into the market via a covert version of QE3.
The Fed is sending billions of dollars to Europe through its U.S. dollar liquidity swap agreement with the European Central Bank (ECB). In addition to the Fed’s donation, the ECB is providing unlimited, three-year 1% loans to European Banks. This is not officially QE3, but it’s pretty close and it does the trick for stocks. This liquidity wave benefits European stocks (NYSEArca: VGK) as well as international (NYSEArca: EFA) and emerging market indexes (NYSEArca: EEM).
But there’s also a similarity between 2012 and 2011 in terms of the rally’s technical structure.
The October 11, 2011 ETF Profit Strategy Newsletter anticipated that: “This rally from the 1,075 low is a miniature version of the March 2009 – May 2011 rally. I expect some difficulties in forecasting the exact route (including the end) of this rally.”
The above assessment followed the October 2 prediction of a major market low: “The ideal market bottom would see the S&P dip below 1,088 intraday followed by a strong recovery and a close above 1,088. From a technical point of view this counter trend rally should end somewhere around 1,275 – 1,300.” S&P 1,300 sounded ridiculous at the time, but look where the S&P is today?
Will Stocks Continue to Rally?
Purely based on past performance and statistics, it is near certain that major market indexes like the Dow Jones (DJI: ^DJI), S&P (SNP: ^GSPC), Nasdaq (Nasdaq: ^IXIC) and Rusell 2000 (NYSEArca: IWM) will end 2012 with gains.
The Stock Trader’s Almanac follows three separate indicators, all of which are pointing towards full year gains:
Santa Claus Rally (SCR): If Santa fails to call, the bears may come to Broad and Wall. There was a 1.9% SCR gain, so the bears are unlikely to occupy Wall Street.
First Five January Days: The first five January days are an early warning system, but the S&P was up 1.8%.
January Barometer: As January goes, so goes the year. The S&P was up 4.36% in January.
Composite Indicator: Since 1950, there have been 27 years (including 2012) where all three above indicators were positive. Full year gains followed 92.3% of the time.
Fly in the Ointment (or on the Windshield?)
This all sounds great, but we should keep in mind that 2011 started out exactly the same way. A positive SCR, first five days and January Barometer coincided with a low VIX (Chicago Options: ^VIX) reading and were followed by a financial yo-yo ride.
The chart below shows the S&P’s performance from January 1 – August 1, 2011. Despite much fluff and good will established early in the year, stocks didn’t go anywhere the first eight months (or the entire year).
Keep in mind that 2011 was also a pre-election year, the strongest of the 4-year election cycle. There hasn’t been a down pre-election year since 1939. The S&P avoided breaking that streak by a mere 0.1%.
In summary, seasonality-based statistics are great, but they need to be taken in context with a big picture approach to investing.
I thought the market would reverse in the 1,307 – 1,330 range. 1,307 is the 78.6% Fibonacci retracement of the points lost from May – October 2011 and 1,328 is trend line resistance going back to October 2007.
But, there's a more important trend line a bit higher. In April 2011 this trend line traversed through 1,377. The April 2, 2011 ETF Profit Strategy update referred to this trend line and warned that: "The 1,369 - 1,382 range is a strong candidate for a reverse of potential proportions." The S&P reversed at 1,371.
With the S&P nearing that trend line, we should not forget that if you take away the key ingredient from a momentum-driven market - momentum - you get a house of cards that quickly crumbles. The last several years provide many examples of such post-momentum meltdowns.
What will constitute broken momentum and how far could momentum take stocks?
The ETF Profit Strategy Newsletter identifies the two key levels (one is support beneath current prices and the other is trend line resistance that serves as target for this rally) that are likely to break momentum and increase selling pressure.