Beware the January effect when plotting strategy

Going strictly by the numbers, a positive month is welcome at any time of year. Yet there’s something special about January, since it’s often seen as a fresh start and as a bellwether for the rest of the year.

So far, so good. Since New Year’s Day, stock markets around the world have mostly been heading up. So have mutual fund returns. On average, every single fund category — whether equity, balanced or fixed income — produced positive returns in January.

Can the markets, and funds whose returns are related to these markets, keep it up? To answer that, there are various indicators, ranging from the whimsical to those that have some substance behind them.

First, the fun stuff. The Super Bowl indicator holds that if one of the original National Football League teams wins the championship game — as the New York Giants did last Sunday — the U.S. stock market will have a positive year. Over the past 45 years, the Super Bowl indicator has “called” the market’s direction correctly 36 times, or four years out of every five.

The more credible indicators are based on market performance, as opposed to football scores. Commonly cited at this time of year is the January effect: as January goes, so goes the year.

Let’s hope so. The S&P/TSX Composite Total Return Index, which includes dividend income, gained 4.4 per cent in January. South of the border, the S&P 500 Index Total Return Index was up 4.5 per cent in U.S. dollar terms, and 3.3 per cent when translated into Canadian dollars.

A strong positive return in January, even if it’s only one month, tilts the odds in favour of a winning year. The market’s long-term direction is up, so that helps too. This year, even if the markets experience a modest loss from February through December, the full-year return could still end up positive. Bear in mind, though, that a calendar-year return could be positive but still below the long-term historical average. Whatever you do, don’t take January as a signal to increase your stock-market exposure beyond your personal comfort zone. In Canada, especially, January has proven to be an exceedingly unreliable indicator of what the market will do.

Over the past 25 years, according to research by my colleague Patrick Ip, manager of Canadian equity data for the CPMS division of Morningstar Canada, the January market barometer has had only a 52 per cent success rate. Flipping a coin would have had nearly the same predictive value In the U.S., the January effect appears stronger. It had a much better success rate of 68 per cent over the same period. The S&P 500 Index of U.S. stocks moved in the same direction in January as it did in the full calendar year in 17 out of the past 25 years. Ip observed that January may be a more reliable barometer south of the border, since large U.S. companies typically release their financial results and earnings guidance earlier in the year than Canadian companies do. Since investors in U.S. stocks have more up-to-date information earlier in the calendar year, their buy or sell decisions in January are more likely to be indicative of how the year will unfold. Even so, the January effect has failed to materialize in the U.S. in roughly one out of three years. This is not a success rate that should inspire confidence or form the basis of an investment strategy. Perhaps more than anything else, the mixed track record of the January effect goes to show that shortterm market movements are erratic and unpredictable. So when crafting your investing game plan, you should consider how markets have tended to perform over much longer periods than one year, let alone one month. rudy.luukko@morningstar.com