Does the January effect signal a good year for equities?

Ben Graham, Warren Buffett’s mentor and the father of modern share analysis, explained the ups and downs of the market to his students like this – he told them to imagine they were part-owner of a business with a neurotic partner called Mr Market, who every day would offer to buy their share in the business or sell his own share to them at a given price.

His dramatic mood swings, from extreme optimism to deep pessimism, meant that the price he quoted fluctuated wildly from day to day.

Graham’s point was that the level of the market was unrelated to the intrinsic value of the companies quoted on it. Depending on Mr Market’s mood, it could be well above or well below fair value.

The wise investor would sell when Mr Market was bubbling over with enthusiasm and offering a high price, and would take the opportunity to buy when Mr Market was irrationally gloomy and prepared to accept a low price.

Since the New Year, Mr Market’s mood has picked up dramatically and the price he is quoting us today is not far off last year’s peak.

The US market is 20% higher than its low point in October, fulfilling the usual definition of a bull market in three months.

There are some good reasons for Mr Market’s renewed enthusiasm. There have been some real improvements in the data coming out of the US. Fourth-quarter GDP growth of 2.8%, for example, underscored the yawning gulf opening up between a recovering America and other slowing developed economies.

Elsewhere, China looks more likely to enjoy a soft than a hard landing and the European disease looks more chronic than acute this weekend.
But the real change has been in Mr Market’s mood. The glass simply looks half-full again.

Morgan Stanley recently asked its clients what they felt about various aspects of the market, and their answers are revealing. They show an almost complete turnaround from the gloom and doom prevailing just a few months ago. For example, asked whether China would suffer a hard landing in 2012, 76% said no and just 6% thought it would. Almost half of the respondents rated the probability of a US recession this year or next at under 20%.

Perhaps because of that, 40% of the investors questioned said that they expected the US to be the best-performing developed market this year.
In a further sign of renewed confidence, 40% also thought that the best-performing sector this year would be Financials, hardest hit last year by the eurozone crisis, with a further 22% favouring industrials, one of the sectors most intimately linked to the health of the global economy.

More than half of investors said that equities would be the best-performing asset class this year after last year’s unexpected trouncing by government bonds.

It is not just what people are saying but what they are doing that indicates a significant change of heart.

A key measure of investors’ enthusiasm is the ratio of positive bets on the market (calls) to negative bets (puts). The speed of the move from down to up bets has only been exceeded once since the data started to be collected 17 years ago.

Another technical measure of the strength of the market’s upward momentum, known as the relative strength index, has barely been beaten in the past five years, including during the rapid market recovery that began in early 2009.

It’s all rather encouraging for believers in the “January Effect”, the old stock-market adage that says that the first month of the year sets the tone for the remaining 11 months.

As with “Sell in May and go away”, the January Effect does actually seem to be more than an old wives’ tale. The hit rate is safely above 50% and the average performance of the market in years with a positive January is getting on for twice as good as the average for all years.

Is all this exuberance a reason to be cautious? In the short term, I think it is. But extreme sentiment is a much better contrary indicator at the bottom of the market than the top.

When everyone hates the idea of investment, you really ought to be tempted; when the mood is more positive, it’s less clear-cut. That’s especially the case if valuations have not yet caught up with Mr Market’s perkier mood. He could remain cheerful for a little while yet.
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