By Mingze Wu
Stocks closed out January lower despite the so called "January effect," with predicts that stocks should be more bullish in the month of January. However, it should be remembered that January effect is a 2 parter - 1st part talks about the gains in Jan itself, while the 2nd part says that a bullish Jan will result in a bullish year and vice versa. Comparing statistics, the 1st part is only true less than 2 out of 3 times (65.7%), while the 2nd part is slightly more reliable at 71% where S&P 500 is concerned.
However, this 71% does not paint a full picture. If we examine closer, we will notice that out of the 12 years out of 35 where stock prices were bearish in January, the January Effect is only true for 5 attempts, a mere 41.7%. This is a stark contrast to the 20/23 (87%) hit rate for the positive side of January Effect. Hence, it will be more correct to say that the year will have a high chance of ending positive if Jan closes bullishly, but the reverse is not true.
This is not rocket science, and anybody with 15 mins of their time and access to monthly historical data of S&P 500 will be able to make this "discovery." Hence, it is highly unlikely that traders will start selling stocks believing that 2014 will end bearishly. This is not saying that further bearish correction is not possible, but rather if prices do end up lower when we take stock in December, it is unlikely that the supposed January Effect was the reason that led to it.
On the other hand, is there any correlation between Jan and Feb? Since 1950, there have been 25 years where Jan ended up lower, and 15 out of the 25 years February closed in the red as well. Since the index crossed the 1,000 mark, we have 5 out of 7 years where a red Jan led to a red Feb for an average of -40 points. For the remaining 2 years where Feb did not follow suit, the average gain was only +26 points. Hence, if traders want to simply follow the numbers, betting on a Feb decline has a higher hit rate compared to betting that we will end lower in December.
There is some valid reasoning for this phenomenon as well which trend traders will attest to: Momentum. It is more likely that Feb will end lower because bearish momentum in Jan has given bears a head start in Feb. However, it should be noted that there isn't a lot of data points to make the numbers statistically significant. Certainly we can go back further in time, but that would be when S&P 500 is in triple digits, and double digits in some cases, which makes the comparison hard as the situation back then was entirely different. As such, traders should use the numbers provided here with a huge pinch of salt and not bet the whole house on this as what we are seeing could simply be non-statistically significant variations (e.g. the mean could still be 50%).
From a Technical Analysis perspective, the holding of 1,770 continues to give hope to the bulls as the bullish momentum appears to be intact. Similarly, Stochastic readings are pushing above 20.0, giving us a bullish cycle signal. This opens up the potential for price to test 1,812.5 once again, and potentially all the way towards 1,850 if Channel Top is broken. Should 1,770 break (likely if the Jan/Feb bearish relationship holds), we could see strong bearish continuation as the bullish momentum will be heavily impaired. Given that U.S. stocks holders are borrowing a record level of funds in order to hold their current positions, any significant bearish move or a sign of break in bullish momentum will likely result in strong sell-off follow-through as these leveraged buyers are not able to withstand larger declines.