Why Yesterday's Big Rally Means Nothing

For many investors, there's no better way to start off a new year than to have a nice big stock market rally. With great news on the manufacturing front and a rebound from beaten-down financials, the Dow Jones Industrials (INDEX: ^DJI) led the overall stock market strongly higher. But if you believe that yesterday's huge advance somehow predicts an automatically strong year for stocks, 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 stocks 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 stocks 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 semiannual cycle that most people know as the "sell in May" indicator. With stocks 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. For instance, in the early part of the year, limits on contributions to retirement plans like 401(k)s and IRAs reset, allowing those who hit their previous-year maximums for retirement saving to start making new investments again.

In addition, the removal of some selling pressure may contribute to upward price moves. Late in December, some investors scurry to sell their shares to lock in tax losses for their April tax filings. By January, that opportunity is gone, so those who had been selling stocks are no longer pushing prices down. Moreover, for those who sold to harvest tax losses but want to buy back shares, January is often the first time they can do so without facing wash-sale rules.

What a day!
The effect seemed to work great on the year's first trading day. Stocks rose broadly, with gains pretty much across the board.

Moreover, some of the big gainers were the same stocks that had dropped severely in previous weeks. Eldorado Gold (NYS: EGO) and NovaGold Resources (ASE: NG) were the worst-performing gold stocks with market caps above $1 billion over the four weeks that ended 2011, but both of them jumped 7.5% yesterday as gold prices rocketed back over the $1,600-per-ounce level. Eldorado is working through a deal to buy European Goldfields, while NovaGold built on gains that followed the November announcement that hedge fund Baupost Group picked up shares in the third quarter of 2011.

Elsewhere in the metals space, steelmaker Mechel (NYS: MTL) and rare-earth specialist Molycorp (NYS: MCP) also reversed 20%+ losses in late 2011 with jumps, as both stocks rose on strong industrial economic data in the U.S. and China. Mechel rose in line with other steel companies. Molycorp got the added benefit of announcing some new contracts with customers.

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, stocks often fall back.

For instance, last year, the stock market rose strongly the first day and posted a gain of better than 2% for January. But by the end of the year, the S&P 500 had given back all those gains. That follows experiences in 2009 and 2010 in which the market jumped early in January only to post losses by the end of the month.

What to do
When you own stocks 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 stocks can beat it. We've found 11 powerful stocks and named them in The Motley Fool's latest special free report on dividends. Don't wait -- get your free copy right now and start the year off right.

At the time thisarticle was published Fool contributor Dan Caplinger appreciates a good rally, although he'd like cheaper stocks to buy. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy means everything.

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