January barometer for stocks

Here's what January's down month might mean for the rest of 2022.

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A widely followed market theory, popularized by the Stock Trader's Almanac, claims that as January goes, so goes the full year. The S&P 500 lost 6% in January 2022, the worst first month of the year since 2020—when the COVID-19 pandemic was beginning to unfold. Followers of this indicator might say investors may want to exercise caution for the rest of the year. But there are reasons to take the January barometer and other calendar-based trading patterns with a grain of salt.

Momentum halted

By the end of 2021, US stocks rallied more than 28% and global markets rallied 21%, as historic levels of government and central bank support helped drive many asset prices higher. That momentum did not carry over into this year, and in fact this was the third straight year that US stocks have lost ground in January (see Stocks lose again in January chart).

So, does this year's 6% January loss point to a down year for US stocks? Not necessarily.

Momentum is one of the primary reasons why some investors give credence to calendar-based chart trends like the January barometer. The thought process here is that a bullish (or bearish) start will set the market in that direction for the rest of the year. For example, a 2% gain for the S&P 500 in January 2017 preceded the 19% full-year rally, and an 8% January gain in 2019 concluded with a 28% rally.

What is noticeable now, compared to the previous consecutive down Januarys, is that the decline is substantially larger this year. With that said, while the January barometer might help trend traders assess the direction of short-term momentum, more important factors right now remain COVID developments, next steps by the Federal Reserve, and corporate earnings trends.

A bullish start is the stronger predictor

Based solely on the past performance of the US market, an up January has generally been bullish for stocks. That has been particularly the case when the market has gained more than 5% in January.

Moreover, the January barometer has held true roughly 75% of the time since 1945 when January experienced market gains. Notable exceptions followed extended periods of market growth. Conversely, a down January has not been a reliable predictor of an overall weak year. Thus, the down start to 2022 may not be indicative of a down year overall, as historical trends are not a guarantee of what will happen in the future.

Taking the January barometer's temperature

Why might up Januarys be better predictors than down ones? One reason may be the historical proclivity of stocks to rise. US stocks have finished higher in all but 17 out of 76 years since 1945. So, the fact that stocks finish higher for the year so often after both a positive and negative January may simply be the result of this directional bias.

Indeed, there is a strong correlation between positive January S&P 500 performance and positive market performance for the entire year. During only 2 years since 1945 have stocks dropped sharply (a price decline of more than 10% for the full calendar year) after a positive January, with both instances occurring at the end of powerful multiyear market advances (1966 and 2001).

Moreover, a down January may not be a reliable predictor of a weak year overall. Going back to 1950, in 14 out of 28 years when January finished in the red, the stock market actually ended higher, and often by a very substantial amount. That was the case in both 2020 and 2021.

First 5 days

In addition to the January barometer, some market watchers place particular emphasis on the first 5 trading days of January as an indicator of where the market is headed for the full year. Stocks lost 2% during the first 5 trading days this year. The first 5 trading days of 2021 saw US stocks add 1.8%, culminating in a 28% gain by year end. In 2020, a 1.4% gain during the first 5 days ended with a 15% advance, and in 2019, a 2.7% gain during the first 5 days culminated in a 28% full-year gain.

A major problem with this theory is that the sample size of trading days is small (5), compared with the January barometer (typically about 20—which is also not a large sample size), to be a reliable predictor of momentum for the rest of the year. Given the small number of trading days associated with the first 5 days theory, there does not seem to be enough time for momentum to become a significant factor.

Investing implications

Many investors like following the January barometer because it provides an easily identified outcome. While it is impossible to predict the future, proponents of the January barometer think this indicator may provide some indication of the momentum behind stocks.

But beware of crafting a strategy solely on this theory, or any other technical theory or fundamental indicator. Each year is unique, as the factors impacting the market are constantly changing.

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