First, going at least as far back as the 1940s, the so-called January effect is a well-known bias in individual stock behavior in which stocks that lose value at the end of the year tend to reverse those losses in January.
The other January effect, which I use in my study, refers to evidence published in 2005 suggesting that January’s returns hold predictive power for the remainder of the year.
More specifically, this effect claims that when stocks go up in January, they tend to continue to climb for the rest of the year, and vice versa – regardless of the impact of other usual drivers of stock market returns. On Wall Street, this effect is often dubbed: “As January goes, so goes the year.” For the rest of the article, for simplicity’s sake, I’ll call this the January effect.
Second, I combined this January effect with the four-year presidential election cycle (PEC) to see how it influenced January’s predictive abilities. The PEC refers to a cycle in which U.S. stock market returns during the last two years of a president’s term tend to be significantly higher than gains during the first two years. This cycle is especially true for the third year of a president’s term, which has almost always been positive.
For my study, I wanted to see if the timing of the presidential cycle (first year, second year, etc.) affected January’s predictive abilities. I studied monthly returns (without dividends) of the S&P 500 over the 67-year period from 1940 through 2006.
January’s predictive power
Overall, my results were consistent with the paper noted abovedemonstrating that positive returns in January typically portended gains during the other 11 months of the year, as well as the opposite.
They further showed, however, that January’s predictive power is most convincing during the president’s first and fourth years in office. Since, at the moment, we care most about the first year of a president’s term, I’ll focus on those results.
Over my sample period of basically 17 election cycles, I found that during the president’s first year in office, average returns for the 11 months following a positive January were 12.29 percent, while a negative January led to average losses of 7.91 percent over the remainder of the year. That’s a difference of more than 20 percentage points – or over US$200,000 on a $1 million investment.
Furthermore, I found that a positive or negative January predicted returns for the remainder of the year almost 90 percent of the time, suggesting a very strong correlation.
Recent results have been split
Since my study was published, there have been two more elections, one of which ran contrary to the January effect, while the other confirmed it.
After President Barack Obama won the 2008 election, the S&P 500 lost 8.6 percent during his inaugural month of January. But the market rallied for the remainder of the year by about 35 percent.
Conversely, after his reelection in 2012, stocks returned around 5 percent in January 2013 and, consistent with the other January effect, the market climbed another 23 percent over the remainder of the year.
What’s behind this?
So what’s driving the effect?
Exactly what drives this effect is a topic of debate. For example, I tested whether it may be driven by monetary policy, which did not seem to be the case.
A common argument for the PEC is that it reflects investor views of fiscal policy, which is why returns during the second two years of the cycle tend to be higher than the first two. Yet my most significant results were for the first and fourth years.
Nonetheless, while I did not specifically test for fiscal policy influences, it seems valid since my results showed that January’s effect appears to be the most reliable during the president’s incoming year in office. The effect wasn’t nearly as pronounced during the other three years.
So far, that seems to be the case at the moment as the “Trump rally” appears to be a response to anticipated fiscal policy.
What to expect in 2017
Of course, there is never complete certainty in the markets, especially with an unavoidably small sample size like 17 election cycles. Still, the results of my study provide compelling evidence that, particularly in the president’s first year in office, January’s returns appear to capture information that is valuable for anticipating returns for the remainder of the year.
As of Jan. 10, the S&P 500 was up about 1.5 percent for the year and near its record high of 2,282, while the Dow continued to flirt with that magical 20,000 number.
While January’s full-month returns are not yet known, history strongly suggests that investors would be wise to closely monitor the S&P 500. If January 2017 remains positive for U.S. stocks, returns for the remainder of 2017 may very likely also be positive. The opposite can also be expected.
So for investors looking ahead in 2017, as January goes, perhaps so will the remainder of 2017.
All risk markets have and continue position themselves in preparation of a super fiscal boom emanating from the Republican controlled Congress in the first term of Donald Trumps Presidency. And why not – he has promised the wall, I mean the world in terms of infrastructure spending, repatriation of US industry, and huuge tax cuts that should trickle down to the beleagured middle class.
And in a repeat or echoing of the Reaganite 80’s, a new cold war in defense spending, particularly nukes and Navy, even if military stock prices take a hit whenever Trump tweets about his dissatisfaction with Boeing products.
But what if this fiscal boom doesn’t eventuate? There’s some solid roadblocks ahead to consider, particularly Trumps penchance to start new trade wars.
From Bloomberg:
The recent surge in bond yields was driven by positive economic developments before the election, as well as in anticipation of fiscal stimulus, said Torkild Varran, chief executive officer of DNB Asset Management.
But that trade “may not have fully taken into account what may come of various initiatives from Trump,” Varran, who oversees about 61 billion euros ($64 billion) in assets, said in an interview in Oslo on Tuesday. “We’re a bit concerned that people are thinking that fiscal stimulus is coming faster than it de facto can come. Or, that it never comes at all.”
The World Bank this week said that, while Trump’s fiscal policies could jump-start the global economy, it would be unwise to ignore the risks posed by his declared preference for trade barriers. It kept its forecast for U.S. growth this year and next unchanged, at 2.2 percent and 2.1 percent, respectively, without incorporating the expected effect of Trump’s policy proposals.
“We think yields are going to rise, but expect a bit of a recoil if long yields rise a lot,” Varran said. “We don’t believe that growth will be ultra-fast or that we will see a situation where the Fed will have to tighten significantly.”
“Some of the forces toward lower rates will continue to be in play,” he said. “We don’t have any big belief that inflation will rise much more from here.”
“We think 2017 will also be a good year for stocks, but not necessarily very good,” Varran said. “But enough to get the risk premium out of the stock market.”
Given that most stock markets are already at ca. 20% year on year in terms of performance, that risk premia might be hard to find in 2017 if the fiscal fizzer eventuates.
Some quant analysis from Ray Sturm might provide some insight on how to position for this risk. From The Conversation.