2012 Off to a Good Start - Will it Last?

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2012 seems to be off to a good start - so far the S&P is up 20.21 points or 1.61%. A closer look however shows that all of those gains occurred within the first hour of trade on January 3rd. There've been no further gains since.

One good hour doesn't make for a successful year, just as one sunny day (or hour) doesn't make a summer. Can this rally outlast the many bearish head winds? Here are some of the problems stocks will have to overcome:

The January Effect

The S&P has a tendency to record some kind of a top in January. This was the case in 2008, 2009 and 2010. QE2 continued to push stocks higher in 2011. Since 2002, the S&P reached a January top followed by a drop greater than 8% five (out of ten) times.

When the S&P didn't fall in January it reached some kind of a high (in February or March) followed by a decline greater than 6%, four out of five times. Detailed results are shown below.

                               

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Mean Reversion

Early new-year declines seem to be a part of the mean reversion process. End of year bullishness seems to be a reliable fixture of the seasonal calendar. Higher prices stroke investors' egos, which results in a higher percentage of bullish investors.

Excessive bullishness almost always leads to lower prices and January commonly puts a damper on the Santa Claus Rally bullishness. This year appears to be no exception.

Take a moment to read some of the 2011 forecasts published in December 2010:

'Experts agree: Get over your fear and get back into stocks' - USA Today

'10 strategists see the S&P finishing next year 1,373' - Barron's

'Long way from dog days: 2011 might see record Dow' - AP

Following a strong year-end performance, not only the S&P (SNP: ^GSPC - News), Dow Jones (DJI: ^DJI - News) and Nasdaq (Nasdaq: ^IXIC - News) have gained steam, investor sentiment is also at the highest level since mid 2011.

The Euro Can't Find Support

Even though U.S. equities are hanging tight, the euro (NYSEArca: FXE - News) just can't find support and fell below the April 2009 and January 2011 low at 1.287. The dollar (NYSEArca: UUP - News) on the other hand keeps going up.

Gold (NYSEArca: GLD - News), and silver (NYSEArca: SLV - News) prices add an interesting twist as they move higher despite a falling euro.

Resistance Ahead

Via the November 30 ETF Profit Strategy update I reasoned that: 'Based on seasonality and today's volume it appears that higher prices are likely. I would like to see a slow grind higher within the 1,226 - 1,xxx (reserved for subscribers) range that takes all of December and early January. This would suggest a virtually untradeable December followed by a great opportunity to go short in January.'

We got higher prices amidst a 'virtually untradeable December.' The rally doesn't have to be over just yet, in fact I'd like to see the Dow Jones and S&P push up to test some previously formidable trend lines.

There really are two separate trend lines and a number of important Fibonacci levels that make up a strong resistance cluster. One trend line is nearly 15 years old and marked the May 2011 top. This trend line ran through 1,377 in April, when the April 3 ETF Profit Strategy update stated that: 'In terms of resistance levels, the 1,369 - 1,382 range is a strong candidate for a reversal of potentially historic proportions.'

The second trend line has kept a lid on every advance since the October 2007 top. The various Fibonacci resistance levels coincide with the retracement levels of most counter trend rallies since the 2007 high. In short, this resistance cluster looks pretty daunting.

High Probability in the Making

There is no such thing as a 100% correct forecast. Investing is a game of probabilities and if you keep the probabilities in your favor consistently, you will prosper.

Based on the January effect, sentiment and overhead resistance, I expect a high probability setup to go short sometime in January.

The ETF Profit Strategy Newsletter identifies the target level of this rally (based on various important resistance levels) along with a short, mid and long-term forecast and actionable ETF profit strategies.



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