Will the January Effect Play Out?

02/09/2010 10:52 am EST

Focus: MARKETS

Janet Brown

Editor, NoLoad Fund*X

Janet Brown, editor of NoLoad Fund*X, looks at stocks’ poor January performance and discusses what it could mean for the rest of the year.

Stocks around the world paused after reaching a mid-month peak, capping the strong rally we enjoyed since March.

There was no shortage of good economic news and positive earnings reports recently, yet investors chose to “sell the news.” The Dow Jones Industrial Average fell nearly 4% in January, snapping a string of monthly gains and marking only the second losing month in the past 11 months.

The Standard & Poor’s 500 index dropped 3.6%, and the technology-heavy Nasdaq Composite index tumbled 5.4% over the month. The small-cap Russell 2000 sank 3.7%. Overseas declines were equally widespread.

Last month’s declines came despite a bigger-than-expected 5.7% rise in US fourth-quarter GDP, along with a slew of corporate earnings well above analysts’ estimates. Almost 80% of the S&P 500 companies beat their fourth-quarter earnings estimates so far, according to Thomson Reuters.

As stocks pulled back in January, bond yields retreated, leading to gains in fixed income. Long-term government bond funds gained the most, followed by intermediate-term [bonds] and TIPS. High-yield bond funds and other corporate bond funds brought in good returns. Even short-term bond funds saw decent gains. World bond funds were weakest.

Many have noted the so-called January Effect—as January goes, so goes the year. Since 1950, when the S&P 500 lost ground in January, the average February through December loss was 0.8%, reports Ned Davis Research. When January has been up, the S&P 500 rose 12% on average.

But remember that these are only averages and there are many exceptions. Last year, for example, stocks plunged 9% in January but finished the year 35% higher. In fact, in the last ten years, the January barometer was correct only 60% of the time and was wrong in the two best years.

Is the market’s current dip more than a step back from the continued upward climb? Ned Davis Research reports that the odds of a 10% stock market correction, based on similar periods after the end of a recession and after such a big rally, is very high, estimated at 77%, based on historical market patterns in recoveries.

But, of course, no one knows what short-term market action will be. We do know that after a decade of negative returns, subsequent returns have historically been above average.

All we know for sure is that stocks declined in January 2010. No one knows what the rest of the year will bring. Sooner or later, we will probably face a correction of at least 10%. If that happens now, pundits will use the January barometer to scare investors into thinking the bull market is over.

The truth is, we don’t know what the market will do this year, and neither do they. If market leadership moves us to defensive funds, we’ll buy them. For now, though, we’ll stick with the current winners.

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