When tracking the weather or basketball statistics the end of the calendar year has little effect. January 1st is just another day. Not so when it comes to stocks. According to the phenomenon known as the January Effect, investors—particularly the large institutional investors that dominate the market— tend to follow certain predictable patterns, dumping stocks at the end of the year to improve their portfolios’ year-end appearance and adjusting the realized gains and losses for tax purposes. Then in January they put their cash back to work by buying new stocks, leading to good market performance in the first month of the year.
Whether or not you attribute it to the January Effect, there has been an abrupt shift in market behavior that coincided with the beginning of 2012. One big change this year has been a drop off in volatility. One measure of volatility is how many “all-or-nothing” days there are in the market. These are defined as days when at least 400 of the 500 companies in the S&P 500 moved up or down together. In 2011, according to Bespoke Investment Group, there were 70 all-or-nothing days, the most in recent memory. In 2012 so far there have been none.
Volatility tends to go along with correlation—when stocks swing wildly up and down it tends to be in reaction to large-scale macroeconomic forces that move all stocks together regardless of their individual characteristics. This was the case for much of 2011. To the frustration of stock pickers, everything moved up and down together. This too has changed in 2012. Correlations between different types of stocks swung from record highs in 2011 to record lows so far in 2012. Materials, tech, and financial stocks have soared, for example, while utilities and consumer staples stocks have sunk.
In the new year there has also been an abrupt shift in leadership from large cap stocks to small caps. In 2011 large caps rose 5% while small caps fell 5% as investors focused on the safety of large dividend-paying stocks, but now as investors have become somewhat less risk-averse small caps are up more than 11% compared to 5% for large caps. The tech-heavy Nasdaq Composite which lagged in 2011 is now in the lead, up more than 13% year-to-date. Similarly the lead has shifted from the U.S., which outpaced all major stock markets in 2011, to emerging markets where Brazil is up 18% and Singapore 17% so far this year.
With the strong market performance and the economy showing some signs of strength investors are beginning to feel optimistic again. According to the American Association of Individual Investors survey, bulls now outnumber bears by 51.6% compared to 28.3%, the highest measure in over a year. Whether the market will follow the pattern of last year (when a strong first quarter was followed by a large correction) or whether the market will continue on its present course is still unclear. Certainly there are plenty of headwinds in Europe, China, and the Middle East that could sink the current rally. Either way, the abrupt change in market behavior confirms the wisdom of owning a diversified portfolio of high quality stocks across different sectors and economies, market capitalizations and asset classes, and holding on to them for the long run. This year the market has shown once again that jumping on the bandwagon of the latest trend is a losing strategy.