A Barometer for a Stormy Market

Stocks' performance in January can signal their direction for the rest of the year. Here are some sectors and companies that could buck the downtrend

From Standard & Poor's Equity Research

The Standard & Poor's 500-stock index fell 6.1% in January, marking the fifth worst opening-month performance since 1928. The 7.6% decline in January, 1970, was the largest, which was challenged right up until the last two trading days of the current-year month on intensifying worries over an accelerating slide in U.S. economic growth, and a more broadly accepted perception that the Federal Reserve was increasingly behind the curve in terms of interest rate cuts.

Yet a 75-basis-point emergency cut in the Fed funds rate a week before the January FOMC meeting, followed by the announcement of a 50-basis-point cut at the end of the meeting, combined with better-than-expected durable goods and ISM (manufacturing) reports, gave investors hope that rate cuts and a stimulus package would succeed in averting, or at least minimizing, the impact of recession.

Historically Speaking

The sharp decline in equity prices during January is still cause for concern, however, if you are a follower of the Wall Street adage "As goes January, so goes the year." I first learned of this truism from The Stock Trader's Almanac, which observed that a positive performance by the equity markets in January typically led to a gain for the full year, while a negative performance in the first month usually signaled a decline for the entire year. Since 1945, whenever the S&P 500 declined in January, the S&P 500 fell an average 4.3% for the full year, and posted a decrease 60% of the time.

Whenever the "500" advanced in January, the market continued to rise during the remaining 11 months of the year 85% of the time, posting an average price advance of 11.6%—substantially more than the 9% return recorded by the S&P 500's 12-month price appreciation for all years since World War II.

I believe the "January Barometer" offers correlation with causation for behavioral reasons. I think investors are a lot like dieters—they look to January as a new beginning. With cash on the sidelines, due to the sale of securities late last year, combined with the desire to take advantage of the more favorable tax treatment offered by long-term capital gains, investors are likely to reinvest these assets in opportunities that are perceived to reap rewards over the coming 12 months. This logic has stood the test of time. Be reminded, however, that what worked in the past may not work in the future.

Strong Subindustry Results

Investors may be surprised to discover that they could have reaped even greater rewards by taking a cue from the three S&P 500 sectors or 10 subindustries that posted the strongest results during January. Since 1990, the three best-performing sectors in January posted a compound annual growth rate (CAGR) of 12.4% in the following 12 months (February through January), vs. 8.3% for the S&P 500, and beat the market in three of every four years.

The subindustry-level results were even more encouraging. Since 1970, the 10 S&P 500 subindustries with the best January performances went on to post a 12-month CAGR of 15.4% vs. 7.6% for the S&P 500 (excluding dividends). What's more, this January Barometer Portfolio of subindustries beat the market 71% of the time.

Last year's two January Barometer Portfolios posted mixed results. While the S&P 500 declined 4.2% from Jan. 31, 2007, through Jan. 31, 2008 (excluding dividends), the three-sector portfolio outperformed the S&P 500 by gaining 0.8%. The 10 best subindustries, however, declined 5.9%.

This January, the three best performing S&P 500 sectors were consumer discretionary, financials, and materials, while the 10 best performing S&P 500 subindustries were education services, general merchandise stores, gold, home furnishings, home improvement retail, homebuilding, home furnishing retail, leisure products, regional banks, and trucking. Based on this listing, it is obvious to me that investors are expecting many of the previously beaten-down consumer discretionary subindustries to stage dramatic recoveries in the year ahead.