January May Prove Telling


Stocks have rallied on mostly encouraging economic data, with the Dow Transports reaching fresh 14-month highs and the Dow Industrials moving to the high end of a five-week trading range. The health-care sector has rallied on relief regarding reform bills passed by the House and Senate, while technology stocks have benefited from favorable earnings news. For now, we’re holding 20% to 25% of equity portfolios in short-term bonds.

Seasonal influence

The January barometer — the idea that the market’s change in January indicates the direction for the full year — has lost some of its reputation for accuracy in recent years. This year’s results, with the worst-ever January for the S&P 500 Index followed by a big rally, have not helped. But the January barometer was already under attack from statistically minded skeptics, who note that the inclusion of January’s returns skew the historical record.

Still, as January goes, so goes the full year nearly 90% of the time. Since 1940, the S&P 500 Index has suffered a full-year loss 20 times, according to analysts at brokerage Miller Tabak & Co. Sixteen of those 20 years began with a loss in January. January’s record of foretelling the subsequent 11 months is not as impressive, but a positive January has been a statistically significant predictor for February-through-December periods.

January tends to be a positive month, presumably because investors fund retirement and other plans at the beginning of the year. When stocks fail to rally in January, especially in the first five days of the month, many investors see it as evidence that seasonal influences are being offset by unfavorable supply-demand conditions in the stock market. For two key reasons, we see next month as an especially crucial January:

First, with stocks moving steadily higher since March, many portfolio managers are worried about losing any relative performance by being out of the stock market. Once the calendar turns — and portfolio managers have nearly 12 months to make up any relative performance gaps — the incentive to stay fully invested may diminish.

Second, individual investors have viewed this year’s rally skeptically, with $36 billion in net outflows from U.S. stock funds this year. After looking at the market’s 2009 returns and the puny yields available on money-market funds, will individuals decide it is time to bet more heavily on stocks? Or will they decide to get out while the getting is good? We shall see.

Our advice

Partly because we have not seen a bull-market signal under the Dow Theory, holding 20% to 25% of equity portfolios in a short-term bond fund seems prudent.

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