Framing Yesterday's Market Move

Includes: SPY
by: Ploutos

The first trading day of 2012 felt historic. A bipartisan agreement on the fiscal cliff, while far short of the Grand Bargain we had hoped for these last two months, came at the eleventh hour on the first New Year's Day vote since the Korean War. Putting yesterday's move into perspective, the S&P 500 (NYSEARCA:SPY) had its fifth largest gain for the benchmark gauge and its predecessor indices since 1928.

I honestly thought the market would fade the rally. After all, the timely fiscal cliff agreement delayed the sequestration cuts by only two months and did not address the looming debt ceiling breach in early March. Even if this market move proves to be only a temporary respite from political uncertainty, at least we have appeared to avoid an austerity-driven recession in the short-run. While the deal was lacking, it was enough to start investors off with a 2.5% bump to 2013.

Was yesterday's move as important as it felt, or will it just fade into the fabric of the coming year as just another trading day? Market moves on the first day of the year do appear to have some predictive power for annual performance. When the return on the first trading day has been positive, markets have been up on the year 67% of the time. When the first day return is negative, markets have been down 64% of the time.

While this could all be statistical noise, the variability of returns on the first day of the year are about 25% higher than the average variability of returns on all other days. Market participants appear to position their bets for the year aggressively on the first trading day, and more often than not they have predicted the directionality of returns for the remainder of the year. Behavioral economists have found that investors often anchor on a forecast and fail to adjust appropriately as new information is received, which may feed into this relationship between first day returns and annual returns.

Below are historical first day moves when the market has moved +/- 1 standard deviation above/below the average daily return of +0.03%. The difference between average returns for the outlying advances is over ten percent greater than the average of the outlying declines, highlighting again the use of the first trading day as a market signal. Of course, if the first trading day's positive return was a sure sign of outperformance, then market participants would adjust accordingly to arb this anomaly. While there appears to be some merit to the first trading day as a predictor of annual returns, the second highest first trading day was in 1932, which witnessed the largest annual decline for the benchmark Standard and Poor's gauge amidst the Great Depression.

Hopefully, this article puts yesterday's market advance in an interesting historical context, but whether the first day's advance will be a harbinger of positive annual returns will in part still be driven by our political process. If we can find a balance between necessary austerity to right-size our fiscal imbalances without choking off the broadening economic recovery, then the market will deliver a strong performance in 2013 It's a big "if," and while yesterday's historic market move signaled confidence in our nation's ability to strike this balance, we will learn more in the coming months.

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.