Will the 2006 Year End Rally Continue into 2007?

January 3, 2007 – This is inherently a difficult question to answer because though U.S. markets will continue at least for now to drive the global markets in both negative and positive manners and China will continue to drive Asian regional markets, there will always be significant differences in the market performances of different countries.

However, for those markets that experienced a significant year end push, I advocate extreme caution as nothing goes straight up without significant corrections. Investors often succumb to the recency effect, quickly forgetting the historical behavior of markets. For example, because the India Sensex ended up about 47% for the year, most investors have already forgotten the 40% freefall of last May and June in the index that caused many investors to pull their hair in grief.

There is a general feeling of euphoria in some markets that is unwarranted by the realities and underlying components of the local stock markets. When year end rallies pushed some of my stocks from 75% gains into over 100% gain territories, I sold them to lock in my gains, and I would recommend that you do the same if you haven’t already done so. While it is true that irrational behavior can continue for what seems to be inordinately long periods of time, and while we’ll probably see some positive activity in the global markets to begin 2007 that will cause people to lose all fear of a correction, I would personally only look to purchase asset classes or stocks that have recently experienced significant corrections. The risk-reward set-up for purchasing stocks in markets that have done nothing but rise higher for the past couple of months is just not good.

If you read my last blog entry of 2006, you will see that not everything is as it appears on the surface. Certainly sometimes the self-fulfilling prophecy effect comes into play as well. An example of this is the well-documented “January effect”, in which small-cap stocks outperform large-cap stocks in January. Often, the mere belief in this effect is enough to make it happen. For example, if millions of people believe in this effect, the effect will replicate itself again this January specifically due to the fact that millions of people will act on their belief and create enough buying volume in small-cap stocks to push their prices higher.

However, what is infinitely more important is to keep track of the long-term trends. What is more likely to happen down the road? As an investor, you need to think like a chess player, eight-steps ahead of the market. In doing so, not only will you not be caught off-guard by rapid shifts in market behavior, but you will better yet, be well-positioned to benefit from market downturns as well as market bull legs.

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