Riding the Bull

by: Sean Hannon

Given a choice between boring predictability and excitement, I seek the former. Unexpected news flashes that cause leaps in stock prices quicken the pulse, but I am not seeking an adrenaline rush. My goal is to deliver tremendous gains by routinely compounding profits. Repeat this process often enough and your portfolio prospers.

With a penchant for predictability, I enjoy Januarys. I do not possess a crystal ball that sees the future, but I am fairly certain of a topic which will soon crowd the investment airways—the January effect.

Many investors hold one of two main beliefs regarding the significance of the month of January. One theory holds that as January goes, so goes the entire year. For these believers, the road to February will be a long one, marked with earnings reports and economic announcements.

A second camp holds that if the first five trading days of a given year are positive, the remainder of that year will be positive as well. For these investors, the future is bright.

It may seem absurd to base a full year on five days, but of the last 37 times the first five days of the year were positive, full year gains occurred 32 times—an 86% accuracy ratio. As of Wednesday’s close, the Dow Jones Industrial Average (Dow) has closed higher each of 2011’s three trading days for a cumulative gain of 145 points. Heightened expectations for Friday’s nonfarm payroll report could provide a quick reversal, but the bulls are prepared to score an early victory.

When they do, I will be surprised. The recent rally has pushed the Dow into severely overbought territory (red arrows). This marks the third such occurrence since April 2010. The prior occasions were followed by quick reversals that left investors chasing the rally with quick losses. Offering a compelling reason for skepticism, do not rush for the exits. A market being overbought does not dictate an impending reversal. Sentiment can cool via a sideways consolidation or markets can continue rallying and extend the market imbalance.

Combine increasing volume, a market which refuses to decline, and January’s predictive power and the bulls retain control. One of my key predictions involved an early selloff, which would allow us to buy-the-dip. It may eventually occur, but how long will the wait be? I have never been one to chase markets higher, but holding a bullish portfolio during a rising market is rewarding. I continue expecting weakness that will unwind the extreme sentiment reading, but until then the trend is higher and we will ride it.