Stock Market Outlook: January Seasonality

On Wednesday (Jan. 18^th), the S&P 500 closed above 1,300 for the first time since July 28th and its 4 percent gain so far in January is the best start to a year since 1987. All this bullish stock market activity is curious given a continuous stream of bad economic news:

• Standard & Poor’s downgrades the credit ratings of nine Euro countries, including France (but not Germany)
• Standard & Poor’s downgrades the European bailout fund
• Egan Jones downgrades Germany
• China’s economy grows only 8.9 percent in the fourth quarter of 2011, its lowest growth rate in two-and-a-half years. Respected investment firm GMO says China faces an “implosion similar to those that befell Japan 20 years ago and the U.S. in 2008”
• The World Bank warns that a “major” slowdown in global economic growth will occur this year due to a “dangerous dynamic” of emerging market central bank tightening and developed market debt-induced austerity programs.
• Stock mutual funds have experienced cash outflows for eight straight months through December, the longest string in at least two decades.
• The Baltic Dry Index, a measure of commodity shipping costs, has plunged 43 percent in the last month alone and is now at its lowest level in three years
• U.S. rail traffic plunged 9.3 percent in the first week of 2012
• U.S. retail sales increased less than expected in December and same-store sales in the first week of 2012 dropped by 5.4 percent – the largest decline since records started to be kept in September 1989 (more than 22 years ago)
• U.S. jobless claims rose more than expected in the first week of 2012

To be fair, there is also some good economic news:

• Italian 10-year bond yields have fallen back below 7 percent
• New York State manufacturing activity increased in January by the largest amount in nine months
• German investor confidence is at a seven-month high
• U.S. corporate CEOs have increased hiring
• The number of publicly-traded shares of S&P 500 companies shrank in the fourth quarter of 2011 for the first time since March 2009. Fewer shares supports stock prices.

When you put all these economic data points together, however, the Economic Cycle Research Institute’s (ECRI) weekly leading index (WLI) continues to show negative year-over-year growth. The WLI’s latest weekly reading shows a decline of 8.4 percent, which is a negative growth rate consistent with past recessions.

The only rationale I can come up with for the stock market’s giddiness is the belief that “things are so bad that it’s good.” This seemingly contradictory concept is based on the theory that a really bad economy will force the U.S. Federal Reserve and the European Central Bank to engage in more money printing (i.e., quantitative easing) which will provide additional fodder to inflate financial assets. Bond king Bill Gross is betting big that QE3 will happen in 2012. It’s hard to be a bear knowing that QE3 could be on the horizon. Another factor pushing U.S. stocks up may be European money fleeing the Eurozone and getting invested here because of our safe-haven status. But I have to believe that most of the European money that has wanted to flee Europe already has, so this buying pressure into U.S. stocks probably won’t last much longer.

Very short-term, the Nasdaq-100 may be on the verge of a decline based on seasonality. According to Jason Goepfert of Sentimentrader.com, the Nasdaq-100 has fallen in price between Martin Luther King Day and the end of January in 10 of the past 11 years. Similarly, options strategist Larry McMillan has discovered a mid-January bearish seasonality followed by an end-of-January bullish seasonality:

A bearish market pattern often emerges, especially in Nasdaq stocks, in mid-to-late January. McMillan said it is a brief period but often offers a chance to turn a swift profit. In theory, he said the market tops out on the eighth trading day of the year and bottoms on the 18th trading day. This year, the dates are Jan. 12 and Jan. 27.

So far in 2012, the market has blown past the predicted eighth-day trading top on Jan. 12^th and looks primed to peak today on the 11^th trading day (Jan. 18^th). McMillan admits that the peak can be as late as the 11^th trading day, which was the case in both 2010 and 2011.

Sounds like a good time to buy a put on the QQQs or the MNX! According to McMillan’s system, you would only hold on to the put until the end of next week. Near the close on Friday Jan. 27^th, you’d sell the QQQ put and go long by purchasing a SPY call and holding it until the close four trading days later on Feb. 2^nd:

On average, the S&P 500 index has risen 8.3 points in those four days with an average gain of 1.2 percent. There have been profits in 21 of the 25 years, McMillan said.

No guarantees, of course, that it will work again this year — the seasonality is well known. But the mid-month bearishness works best when the first couple of weeks of January have been strong (like this year) and the end-of-month bullishness works best when the mid-month weakness actually occurs (stay tuned).

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