January barometer

How might stocks perform in 2021? Here’s what this technical indicator says.

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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. With a down January 2021 (-2%) in the books, one interpretation of this indicator says investors may want to exercise caution for the rest of the year. But there are reasons to take the January barometer with a grain of salt—especially this year, with COVID-19 still casting its shadow over the market.

Momentum halted

The COVID-19 pandemic was beginning to unfold back in January 2020, when the S&P 500 lost 1% that month. But by year end, global markets rallied double digits, as historic levels of government and central bank support helped support global economies and asset prices. That momentum did not carry over into this year, as stocks lost 2% in January (see Stocks lose again in January chart).

So, does this year's 2% 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 indicators 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 during that year, and an 8% January gain in 2019 concluded with a 28% rally. Of course, this pattern doesn't always hold: Last year, the S&P 500 gained 15% after losing 1% in January 2020, and it lost 6% in 2018 after gaining 6% in January of that year.

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. The January barometer has held true roughly 75% of the time when January experienced market gains since 1945. Notable exceptions followed extended periods of market growth.

It's worth noting that a down January has not been a reliable predictor of an overall weak year. Thus, the down start to 2021 may not be indicative of a down year overall. Of course, historical trends are not a guarantee of what will happen in the future, and there are a myriad of other, more important fundamental factors to consider, including valuations, earnings strength, and fiscal and monetary policy, among others.

Cracks in the barometer

Why might up Januaries 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 75 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 13 out of 27 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 2020.

As previously mentioned, momentum is one possible reason that positive stock performance during January can result in positive full-year performance. If the market gets off to a good start, a bullish trading pattern can form, and that can help fuel continued positive performance as investors jump on the trend.

From a historical perspective, there appears to be no clear evidence as to why a negative start does not more strongly imply a negative year, compared with the high correlation of a positive January translating to a positive year. The full-year outcome after a negative January (or a positive January, for that matter) may simply be spurious.

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. The first 5 trading days of this year saw US stocks add 1.8%, pointing toward a potentially positive year for the market, according to this indicator. In 2020, a 1.4% gain during the first 5 days ended with the aforementioned 15% advance, and in 2019, a 2.7% gain during the first 5 days culminated in a 28% full-year gain.

But you need only look to a couple of years ago to see the cracks in this theory. During 2018, stocks gained 2.8% during the first 5 days before finishing the year in the red. One interesting recent occurrence where the first 5 days theory proved particularly unreliable was when stocks shed 4.8% during the first 5 days in 2016, the worst start ever on record. That ended up not being predictive, as stocks rebounded by that year's end.

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 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

While it is impossible to predict the future, proponents of the January barometer think this indicator may provide some indication of how stocks will perform.

However, some of the evidence is not entirely conclusive. Additionally, each year is unique, as the factors impacting the market are constantly changing. Controlling the COVID-19 pandemic, along with continued government support, likely remain the most important factors that will dictate market direction in 2021.

Many investors like following the January barometer because it provides an easily identified outcome. But beware: Crafting a strategy solely on this theory, or any other technical theory or fundamental indicator, is not prudent.

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