Will Santa Visit Investors in January?
Bullish investors would likely have rather received a lump of
coal in their stockings, given the prevailing lofty level of
energy prices, than the uncharacteristically lackluster
performance delivered them by the stock market in the waning
days of 2005. What made the sour ending so unusual was its
defiance of the well-documented normal tendency for stocks to
rise in December, particularly near the end of the month.
December has historically been the strongest month for stocks,
posting a gain over 70% of the time, and the traditional "Santa
Claus Rally" has swept the S&P higher in the last 2 weeks of the
year over 80% of the time since 1950. The trend has remained so
potent for so long that since World War I broke out in 1914 the
Dow Jones Industrial Average (DJIA) registered its yearly high
20 times between Christmas and New Year's, on one of the last 6
days of the year. In the period from 1890 to 1913, when
railroads were the "blue chips" of the era, the Dow Jones Rail
Average or its predecessor, the 20-stock Average, closed at its
annual high in the last week of the year 5 times. So blue-chip
stocks hit a fresh top for the calendar year in the narrow Dec.
26-31 window over 20% of the time (25 times out of 116).
However, in 2005, most stock indexes topped in early to mid
December at their best levels of the bull market that began in
October 2002. The venerable Dow, constrained by weakness in
component General Motors stock, couldn't even get that far,
instead peaking just below its March 2005 top on the day
following Thanksgiving. Then things turned negative. The yield
curve (spread between long- and short-term interest rates)
inverted after Christmas, with the yield on 2-year Treasury
Notes exceeding the rate for 10-year Treasury Bonds. Yield curve
inversions have preceded the last 4 U.S. recessions. Blue chip
stocks, as measured by the Dow and S&P 500, sagged almost 2% by
year-end to finish December at their respective lows for the
month. But 2006 ushered in an explosive rally when minutes
released from the Federal Reserve's last meeting suggested that
the current round of credit tightenings initiated by the Fed in
June 2004 might be nearing completion. The yield curve steepened
back into positive territory and investors rejoiced. Already,
after just 2 trading sessions, the S&P 500 and S&P 400 MidCap
averages recouped all their losses from last month's closing
highs with most other indexes not far behind.
A multi-day cumulative decline in the Dow of greater than 1%
through the end of the year (meaning a new closing low for the
move on the final day), like we experienced in 2005, is so rare
that it never happened before 1966. In 1967 stocks burst out of
the gate immediately and the Dow rose 9 days in a row propelled
by - you guessed it - favorable interest-rate sentiment. On
January 26, 1967, banks cut the prime rate for the first time
since 1960. We decided to take look back at stock performance in
January following all multi-day cumulative declines in the DJIA
of greater than 1% lasting through the end of December to see if
this year's renewed upbeat tone figures to hold up.
1966-67: After a major low in October and subsequent rally, the
Dow Industrials slip 4.27% through the last day of December,
then jump 8.12% in January. The S&P climbs 7.81%. 1978-79: A
much smaller 1.35% year-end decline leads to a January gain of
4.25% in the DJIA and 3.97% in the S&P. The NASDAQ outdoes them
both, rising 6.65%.
1982-83: December's decline: 2.24%. The NASDAQ (+6.86%) beats
both the Dow and S&P, with respective gains of 2.79% and 3.31%,
by a 2-to-1 margin.
1986-87: A 3.05% dip in December gives way to a full-fledged
buying panic. The Dow sets a record with 13 consecutive up days
to start the year and ends January 13.82% higher. The S&P and
NASDAQ skyrocket 13.18% and 12.54%, respectively.
1993-94: December's fall (-1.06%) and January's rise in the S&P
(+3.25%) and NASDAQ (+3.05%) are relatively anemic, but the DJIA
steals the show with a 5.97% surge.
1996-97: Fairly routine. Dow -1.72% in December, but +5.66% in
January; S&P+6.13%, NASDAQ +6.88%.
1998-99: Amid Dot-com mania the DJIA falls 1.5%, then rebounds a
mere 1.93%. S&P +4.1%, but NASDAQ's +14.3% eclipses even the
1987 market.
As you can see, history tells us that the bulls appear to still
have room to run this month based on past market response in the
aftermath of late-December weakness. Two days into 2006, the
DJIA is up 1-1/2% and the S&P 2%. On the heels of a conclusion
to the year like we just experienced, January's average gain in
blue-chip stocks amounts to a healthy 6%. Generally, the bigger
the slide into year-end, the better. December declines under 1%
were omitted, as is a mere single-day drop of just over 1% in
the last session of 2001, which led to a further 1% January loss
in the bear market year of 2002.
The search for trading patterns that surface around the
beginning of the year seems to draw habitual focus from Wall
Street pundits. Not all of those discovered have stood the test
of time. Let's examine how well some of the most notable ones
have fared.
January Effect
The "January Effect" refers to the propensity for small-company
stocks to lead the bullish charge very early in the year. In the
past, January has been the second best-performing month in the
market. Tax-loss selling in advance of the New Year was often
proposed as a possible explanation. No one ever explained why
the effect materialized just as strongly in many countries that
don't tax capital gains. The phenomenon was so pronounced and
reliable that it started to attract widespread attention in
academia. In the late 1980s, a couple of college professors even
wrote a book called The Incredible January Effect.
By 1994, small-cap (small capitalization, based on market value
of outstanding shares) stocks began a streak of 6 straight years
of underperformance relative to their larger counterparts. The
Russell 2000, the best-known small-cap index, actually fell in 7
of the last 11 Januarys (1995-2005), underperforming in 5 of the
7 losing years. The Russell managed to both gain and beat the
blue chips in only 2 of the last 12 years (2001 and 2004). So
far this year, the Russell 2000 is up 2.4%.
Another aspect of the January Effect is the tendency for last
year's beaten-down stocks to shine early in the year at the
expense of former winners. So-called "window dressing" by
portfolio managers anxious to shed unsightly losers before
presenting their year-end reports to clients, as well as a
rebound from tax-loss selling has been postulated. The recent
record is mixed. In the first week of 1999, cyclical stocks
(economically-sensitive industrial companies like Alcoa, GM,
Caterpillar, Dupont and USX) roared, outgaining more popular
consumer stocks by a ratio of 5-to-1 after a flat 1998. But the
red-hot NASDAQ, fresh off a record 1998, picked up where it left
off, trouncing the Dow with 5 consecutive new records and a 6.9%
weekly gain. Value stocks held up better than growth stocks amid
the market's slide in week 1 of 2000, following an unprecedented
massive disparity in favor of growth in 1999 as a whole, a year
in which the tech-heavy NASDAQ rocketed a mind-blowing 85.6%.
But the NASDAQ collapsed beginning in spring 2000, and lost even
more ground to the suddenly less unappealing Dow as 2001 kicked
off. At the outset of 2002, though, the beaten-down NASDAQ
rebounded with far greater vigor than the Dow or S&P.
Will last year's laggards step to the fore in early 2006? Not if
the action on Tuesday, January 3 provides any indication.
General Motors continued its plunge while hot stocks like Apple,
Google and energy companies, thanks to a $2 spike in crude oil,
surged.
January Barometer
As January goes, so goes the market for the rest of the year, or
so the theory goes. And proponents of the "early warning system"
claim to foretell January's direction from its first 5 trading
days. Alas, the first 5 days are part of the month and, when
factored out, exhibit little if any discernable effect on the
remainder. The January Barometer, however, although seemingly
susceptible to the same sort of argument, actually boasts a
better track record than most human prognosticators.
Seventy-five per cent of the time, a winning January foreshadows
an up year. But a down month brings further losses in over 60%
of instances. Bull market climaxes, significant bear market
rally highs and tops leading to prolonged bull market
corrections often arrive in January or at the tail end of
December. Such events are probably best evaluated on a
case-by-case basis.
Small stocks and the last trading day of the year
At one time, secondary stocks could be counted on to invariably
rise on the last trading day of the year. What money manager,
whose compensation typically depends on performance and assets
under management at year-end, would want to cut into profits by
selling at the last minute and perhaps knocking down his stocks'
prices? The NASDAQ Composite, once a pretty good proxy for small
stocks before rapidly growing big technology companies came to
increasingly dominate the index in the 1990s, climbed on the
last trading day in every year of its existence from 1971
through 1999, 29 years in a row. Since 2000, it's fallen 6
straight times. Traders started aggressively bidding up premiums
on futures contracts for the Russell 2000 going into the last
day each year so that even a relatively robust gain in the
underlying index would no longer guarantee a profit. The Russell
2000, along with the S&P 400 MidCap and S&P 600 SmallCap indexes
have also fallen to end every year since 2000, save for nominal
gains on the last day of 2002. It would seem that readily
identifiable seasonal anomalies around the turn of the year are
on borrowed time as soon as they draw wide notice.
What's next for stocks?
There's little evidence that concern applies to the market's
predilection to shake off year-end weakness in January though,
and, in any event, plenty of reasons exist to remain bullish. In
a recent article, we explored historical stock market
performance in the aftermath of 14 separate October lows. The
S&P bottomed on October 13, 2005. Thus far, both the duration
and magnitude of the prevailing leg up remain well short of
historic norms, leaving plenty of upside potential. We found
that post-Thanksgiving ennui like we just experienced is fairly
typical following initial thrusts off October lows, but the
sluggishness almost never persists beyond early January. The
entire advance since 2002 is still rather modest by past bull
market standards and, as its reaction to the Fed news
demonstrates, the market could be poised to leap like a coiled
spring on any unexpected good news after the Dow stayed mired in
a tight 10% trading range throughout 2005. This stock market
displays much in common with the largely analogous markets of
1945-46 and 1985-86, including limited corrections of less than
8%, as witnessed in April and October of last year. Given the
accompanying bullish fundamentals now in place (a stronger bond
market, energy prices off their highs), we expect a continued
strong advance before a final top or larger corrective decline.