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Stocks slump in January: What's next for markets?

The January barometer

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The January barometer

The January barometer
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Investors who dismissed some hoary market rules of thumb last year as old wives’ tales did pretty well. Does that mean it makes sense to ignore the cautionary message of the so-called January Barometer following a decidedly weak first month of 2014?

In 2013, on the way to as 30% ascent, the Standard & Poor’s 500 Index (GSPC) refused to ratify certain seasonal maxims such as “Sell in May and go away.” And the index had a strong September, despite the widely trafficked fact that September is the weakest month for stocks on average.

Now, with the S&P 500 down more than 3.5% in January from its Dec. 31 all-time high of 1848, the January Barometer suggests a higher-than-usual chance of a negative return for the year as a whole.
Yet, as I discuss with Lauren Lyster in the attached video, the record of this indicator has been somewhat stronger in foretelling the rest of a calendar year when January is up rather than down.

Related: Stocks could plunge 50% in the next year or two: Blodget

Specifically, the S&P 500 has followed January’s direction 80% of the time since 1929, though that percentage falls to 60% when January was negative. Since 1950, the market’s record of turning higher after a weak January has been better, and for the Dow Jones Industrial Average (DJI), a down January has meant about a 50-50 chance of declines for the rest of a year.

The broader point is that such seasonal tendencies are simply an expression of past probabilities, and are better viewed as climate instead of weather: a general pattern based on many years’ observations, but nothing that can tell us much about what to wear or how fast to drive on a given day.

It’s true that when such “normal” market patterns are defied, it can mean an underlying trend in stocks is particularly strong, as was the case with last year’s relentless rally. The fact that January brought an anxious tape, vulnerable to global financial contagion and slowdown fears, should put investors on alert for a potential change in trend.

But the past few weeks are probably better viewed as a forced resetting of market expectations that had gotten far too optimistic and unquestioned coming into the year. Investor sentiment, by almost any measure, got to bullish extremes. The consensus expected stocks to beat bonds, large stocks to outrace small ones and a stock-picker’s market rather than one beholden to global “macro” concerns. On each of those fronts, the crowd has been caught off guard, with Treasury bonds rallying, mega-cap stocks leading the market lower and the macro “risk-off” move washing over U.S. stocks.

Related: Emerging markets catch cold, U.S. and Europe sneeze: Shades of 1997?

This corrective process could easily drag on stocks further, as investor sentiment has moderated but hasn’t yet clearly reached outright fearful levels that often demonstrate a pullback is culminating. Some technical observers take heart in the fact that the January decline has merely given back the gains of the final two weeks of December, and that the S&P's lowest close in December was not breached in January – considered a tripwire for a more negative outlook.

With upside momentum thwarted for now, it wouldn’t be surprising if stocks remained on the defensive in coming days. The crucial Chinese markets are closed for a few days for Lunar New Year, there's skittishness ahead of the Sochi Olympics (opening on Friday), the Japanese stock market is undergoing a steep correction and investors are bracing for Friday's January U.S. employment report. 

A further pullback in the market – some are looking for a correction to culminate closer to 1700 on the S&P 500, or another 3%-4% lower – wouldn’t necessarily undercut the rationale for a recovery above the recent index highs. Chris Verrone of Strategas Group points out that the longer-term trend indicators are still positive, and leadership by riskier stocks and sectors such as transportation names is a plus.

So far, too, earnings season has been unfolding reasonably well, with more companies than usual beating revenue forecasts. And U.S. credit markets have remained largely unruffled by the apparent capital flight from many emerging markets, providing decent support to equity valuations while this lasts.

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