As we watched the stock market slug through a rough January, pundits began dusting off one of the more popular investing superstitions – the January barometer. The basic premise is that as January goes, so goes the year. So because the S&P 500 fell nearly 5% in January, is a down year in the cards? And does any real evidence back up this theory? (Curious about how emotions and biases affect the market? Find some useful insight in Taking A Chance On Behavioral Finance.)
Some real underpinnings explain why a bad January doesn't bode well for a great year. When a new year begins, it's a natural time for investors big and small to think about making changes to their portfolio. Maybe a trim or tuck here, or perhaps a bold step forward. Either way, these moves will either add up to more stock purchases (if people feel more risky) or more stock sales, with the proceeds going into safer assets like bonds or money markets. (Treasuries are considered the safest investments, but they should still be analyzed when issued. For more, check out Basics Of Federal Bond Issues.)
So with the S&P 500 falling last month, many investors might wish to enter the fixed-income market to safeguard their investments. However, the recent debt problems arising in Greece may lead to a reversal of the usual investor behavior patterns.
January's Historical Predictive Success
The actual data come out mixed but are still noteworthy. In the post-World War II era, the S&P 500's January performance has correctly predicted the flow of the overall year more than 70% of the time if we exclude years when the stock market index was essentially flat (up or down less than 5% for the year).
It's worth noting that the data here are somewhat deceptive. January tends to be one of the market's best months every year, rising an average of 1.3% since 1929. And because the stock market rises in most years, there's some inherent bias in the data itself. So, while the barometer works well in predicting up years (some studies even suggest that up Januaries mean up years 85% of the time), it doesn't do so well in predicting down years. When January is down, the market continues to fall only 46% of the time.
We also don't have to look far into the rearview mirror to find a time when January threw us a big head fake. January 2009 saw the S&P 500 fall 8.5%, only to finish with one of the best years on record as stocks soared 35% the rest of the way. Anybody who followed the barometer religiously last year missed out on one of the most profitable market swings in a generation.
Even if you were to put 100% faith in the January barometer, you still shouldn't use it to determine whether you're in the stock market or out for the whole year. For one, you'll incur extra costs from all the buying and selling, and there's an opportunity cost for missing out on big moves if the predictor is wrong. Also, no rule says if stocks don't perform, bonds or hard assets will.
Evidence also suggests that other months, such as April and November, are just as good at predicting the year as January. So why does January get all the attention?
Much of it has to do with market – and media – psychology. We love to wrap our heads around the beginning of the year being a stepping stone, as if the stock market has New Year's resolutions just like we do. Another reason why January can be a tone-setter is it's the month when new presidents are inaugurated and new Congresses convene. Government policy shifts are always big stock market drivers, and January is when State of the Union and policy agendas are announced for the upcoming year.
So, has the stock market seen its shadow for 2010? There's a lot of uncertainty out there between a Federal Reserve Board that is considering raising interest rates, credit problems in Europe and an economic recovery that has yet to spur job growth here at home. If these trends reverse in the upcoming year, the predictions laid out by January's performance will not come to fruition. (Find out how current financial policies can affect your portfolio's future returns; read How Much Influence Does The Fed Have?)
Whether the rest of the year follows this trend will depend on these same issues. But the groundwork has not yet been written in stone - that would just be too easy, and the stock market never gives us "easy".
For further reading, check out Capitalizing On Seasonal Effects.