Do you want to know how stocks might perform this year? A widely followed market theory, the January barometer, claims that as January goes, so goes the full year.
A positive backdrop for the January barometer
Heading into 2018, global stock markets had a lot of positive momentum. US stocks—as measured by the S&P 500—gained more than 19% in 2017 on a price return basis. Global stocks—as measured by the MSCI World Index—increased 15%. Strong earnings growth and low volatility helped markets set record highs amid a synchronized global economic expansion. Of course, volatility has resurfaced in recent days.
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 start to the year will set the market in the right direction, propelling it throughout the year.
Last year, a 2% January gain for the S&P 500 preceded the 19% full-year rally. However, this pattern doesn’t always hold. In 2016, the S&P 500 gained 11% for the full year, after losing 4% in January.
So, does this year's 5.6% January gain—the 11th strongest since 1945—point to an up year for stocks? 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 (see S&P 500 returns following 5%+ gains in January since WWII). Indeed, the January barometer has held true 75% of the time when January experienced market gains since 1945. The 2 exceptions followed extended periods of market growth.
Alternatively, a down January has not been a reliable predictor of an overall weak year. 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.
A bullish start is the stronger predictor
Why might up Januaries be better predictors than down ones? One reason may be the historical proclivity of stocks to rise. Stocks have finished higher in all but 16 out of 71 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 very strong correlation between positive January S&P 500 performance and positive market performance for the entire year. During only 2 years 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 12 out of 26 years when January finished in the red, the stock market actually ended higher, and often by a very substantial amount.
As previously mentioned, momentum is one possible reason that positive stock performance during January may actually be a reliable predictor for 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
The first 5 trading days of this year saw US stocks add 2.8%, pointing toward a potentially positive year for the market, according to this indicator. During 2017, stocks gained 0.7% during the first 5 days, en route to a strong full year. By contrast, 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.
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. For example, in recent days, the potential impact of the possibility of rising rates and higher inflation may have contributed to the increase in volatility seen in late January and early February. Many investors like following the January barometer because it provides an easily identified outcome. But beware: Crafting a strategy solely on this theory is not prudent.
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