What Is The January Effect Indicating For U.S. Stocks In 2017?

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by: Daryl Montgomery

Summary

Stock performance in January can give some indication to performance for the rest of the year.

Some areas of the U.S. stock market were flat in January, while others did well.

Fundamental valuations for stocks are at levels at the high end of the historical ranges, so investors should remain watchful.

Stock positions should be kept in the top performing sectors and indexes and rebalanced at least quarterly.

The "January Effect" is one of a number of Calendar Effects where the market behavior at certain times of the year or month either follows a historical pattern or indicates its future market direction. Essentially, if the market goes up in January, the rest of the year should be bullish and if it goes down, the rest of the year should be bearish. There were a number of academic studies that confirmed there was more than a chance occurrence of this taking place during much of the twentieth century. This behavior makes sense because funds tend to be reallocated in the beginning of the year, going into areas considered undervalued and out of areas considered overvalued. This reallocation now takes place more often than it used to, so the January effect may still be valid, but for a much shorter period of time than a year, possibly only as long as a quarter.

What is the market telling us so far in 2017? First of all, let's take a look at the four broad asset classes - stocks, bonds, commodities and cash - and see how they've done in January from the perspective of a U.S. investor. In the chart below, we see the dollar has lost approximately 3% during the month (we are using the trade-weighted dollar, instead of T-bills). A broad-based bond portfolio (NYSEARCA:AGG) would have had a flat return during the month, similar to its return for 2016 overall. U.S. stocks (NYSEARCA:SPY) and a broad-based commodity index (Pending:CRB) would have both returned 1% on the month. Interestingly, U.S. stocks and commodities also had almost identical returns for all of 2016.

Performance of U.S. Stocks, Bonds, the Dollar, and Commodities in January 2017

Of course, not all areas of the stock market did equally well since this is never the case. Although there has been enormous press coverage concerning the Dow breaking 20,000 during January, its total return for the month was around zero percent. The index fell the last few days to close at 19,864, losing all of its upside. The breakout should be considered to have failed. The small cap Russell 2000 likewise offered no return to investors for the month. So there wasn't any indication that investors were giving preference to small caps over large caps or vice versa. The S&P 500 was up around one percent, the Dow Transportation Average around two percent and the top-performing Nasdaq up over three percent in January.

U.S. Stock Index Performance in January 2017

Knowing that the tech heavy Nasdaq was outperformed in January, it would be a good guess to assume technology was one of the best performing sectors in the market during the month. As the chart below shows, the Technology Sector ranked third, with a rise of slightly less than three percent. Basic Materials was the number one ranking sector, with a rise of approximately four percent and Consumer Discretionary ranked two, with a somewhat less than four percent rally.

U.S. Stock Sector Performance in January 2017

The behavior of stocks in January would be considered mildly bullish to neutral by January Effect standards. Small cap stocks should traditionally lead the market if it is to be bullish going forward. They didn't in 2017, and one possible interpretation is that stock performance will be mixed during the upcoming year with some sectors doing well, while others go down. Adding a fundamental analysis to the picture, there is room for caution because U.S. stocks are at the high end the valuation range for a number of indicators.

The CAPE (cyclically adjusted price to earnings ratio) began 2017 at 26.4 for the S&P 500. The CAPE measures current stock price compared to earnings over a ten-year period. It was as high as 27.9 in December. A number over 27. 6 is considered to be in red alert territory. The traditional one-year trailing earnings P/E on the S&P 500 began the year at 21.8, another historically high number. The Price to Book ratio was at 2.9, which is also high. These fairly lofty valuations on stocks exist as the market is facing headwinds from a rising interest rate environment, with the Fed saying it will raise rates three times in 2017.

While investors shouldn't panic, they should remain watchful and keep the U.S. stock part of their portfolios what were the best performing areas of the market in January - the Nasdaq 100 (NASDAQ:QQQ), the Basic Materials Sector (NYSEARCA:XLB), Consumer Discretionary Sector (NYSEARCA:XLY), and the Technology Sector (NYSEARCA:XLK). There is redundancy between the Nasdaq and the Tech Sector so one or the other should be chosen. ETFs that can used to take positions are listed in parentheses. A review of the portfolio distributions based on index and sector performance should be done again by the beginning of the second quarter at the latest.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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