What a Bullish January Means for 2012

January is over and it was quite impressive; not a record by any means, but nonetheless it gives us something to look forward to this year. The key stock indices easily outperformed the historical averages by a wide margin. Technology and small-cap stocks lead the market, with the NASDAQ and Russell 2000 up 7.98% and 6.89%, respectively, in January. The laggards were the blue-chips and large-cap stocks, with the DOW and S&P 500 up 3.56% and 4.41%, respectively. Even Chinese stocks fared well, with the benchmark Shanghai Composite Index up 4.21% in January following losses in 2010 and 2011.

The buying in small-cap stocks suggests continued economy recovery in 2012. So far this year, the housing and manufacturing data are encouraging and point to renewal.

The European debt crisis continues to be a major risk factor. The talks between Greece and its creditors to reach a debt swap deal have yet to be done and there is some speculation the country will be allowed to have a form of controlled default. The problem is that this would likely send jitters through the eurozone and global markets and wreak havoc.

A positive January indicates an up year for stocks in 2012 about 78.3% of the time, according to the Stock Trader’s Almanac, albeit this failed to materialize in 2011.

And, while the upward advance is encouraging, you might recall that there was a similar start in 2011 that ended up in a mixed trading year, with tech and small-cap stocks negative.

While investor sentiment continues to be bullish and market breadth positive, the lack of mass market participation is worrisome and makes stocks vulnerable to downside risk in the event of bad news surfacing in the U.S. and globally.

The charts of the key stock indices are strong; the blue-chip Dow Jones Industrial Average is showing a bullish golden cross with the 50-day moving average (MA) holding above the 200-day MA. On Wednesday, the chart of the S&P 500 turned more bullish, with the 50-day MA breaking back above its 200-day MA, which could signal more gains ahead.

The top two performers, the NASDAQ and Russell 2000, are holding on to a death cross, but even this may turn higher if the buying bias continues.

Small-cap stocks look the strongest on the chart at this juncture and will trend higher should the economy continue to improve.

Small-cap stocks tend to fare well following a recession when the economy begins to grow. After the recession ended in 2009, the small-cap Russell 200 advanced 25.28% in 2010, easily outpacing the 11.02% and 12.74% return of the DOW and S&P 500, respectively.

Yet, despite the overall performance of small-cap stocks, Wall Street focuses on large-cap stocks and those where there are investment-banking fees available. The rest generally “fly” under the radar, being largely under-followed and, thus, by extension, largely undervalued.

My advice is to ride the upward moves, but to make sure you have put hedges in place to protect your gains. It’s also never a bad idea to take some profits.

Reverse mergers are currently out of favor and I expect more of the same this year, which I discussed in How 2012 Is Looking for Reverse Mergers.