Profiting from the January Barometer All Year Long

Since the October 3^rd closing low, the S&P 500 has skyrocketed 25 percent, which has surprised virtually everyone given all the bad news that has occurred in the world since last autumn:

• Standard & Poor’s downgrade of the U.S. credit rating
• the Economic Cycle Research Institute’s (ECRI) prediction that the U.S. is entering a new recession
• the U.S .Congress’ dysfunctional inability to reach consensus on needed deficit reduction,
• the threat of the European debt crisis to cause the Euro to collapse and the virtual certainty of a Eurozone recession in 2012.
• the taxing effects of $100-plus oil and the destabilizing effects of a possible Middle-East war between Israel and Iran. JP Morgan just raised it price target for crude oil to $120 by the end of the year.
• Gasoline prices are the highest ever at this time of year and are likely to rise even higher by the summer driving season.
• As energy trading firm The Schork Group said in a recent report:

A significant run-up in oil prices are an important contributor to an economic malaise. With the U.S. economy starting to show signs of life, high prices now just might kill this recovery in the cradle.

Of course, bad economic fundamentals do matter eventually, but they can be neutralized temporarily by central bank monetary stimulus (e.g., low interest rates and quantitative easing) which is what is happening right now. Economic data has improved lately but it’s not clear how much of the improvement is sustainable and how much is simply due to a very mild winter (warmest since 2006 and the fourth warmest on record). The only certainty is that financial asset bubbles are forming and will eventually burst. As one smart commentator recently wrote:

Bond and currency markets are now so rigged by policy makers that I have no meaningful insights to offer, other than my bubble fears. Liquidity-fuelled rallies courtesy of [U.S. Federal Reserve Chairman] Bernanke and [European Central Bank President] Draghi can last days, weeks, months, perhaps we could even extend into 2013. And the S&P 500 could end up in the high 1500s again if this current binge lasts into 2013. The problem with such liquidity fuelled set-ups is that they can last longer and get bigger than any reasonable logic would dictate.

Enjoy the liquidity ride while it lasts, although there are some incipient signs that central banks are starting to shut off the liquidity spigots, which could stop the rally dead in its tracks sooner rather than later. Cases in point:

• The ECB did not buy any government bonds last week for the first time since August 2011 and rumors are that the ECB plans to end offering low-interest loans to European banks after the February 29^th auction.
• Dallas Federal Reserve Bank President Richard Fisher says that investor hopes for a third-round of quantitative easing (QE3) are “fantasy.”
• The number of Federal Reserve voting members in favor of QE3 is waning. Whereas the December minutes say that “a number” of voting members were interested in “additional policy accommodation,” the January minutes say that only “a few” members are still seriously considering more easing.

The current complacent attitude of central banks would change quickly if economic conditions started to deteriorate, but there would be a lag between realization of economic worsening and additional monetary easing that would almost certainly cause a sharp market decline.

And although Greece has been bailed out, thus avoiding a hard default in March, Harvard University economics professor Kenneth Rogoff was recently quoted as saying that the idea that the European debt crisis is now over “is an illusion.” Greece’s bailout required that private bond investors forfeit 53 percent of the face value of their bonds. If private bond investors believe that Greece is not the exception but the new template for handling the debt of other weak Eurozone countries, a selling stampede may result in order to cash out before a similar sovereign debt write down is mandated elsewhere (e.g., Italy, Portugal, Spain, Ireland). Such mass selling of Eurozone sovereign bonds would jack up interest rates, increase borrowing costs, and make it more likely that these weak Eurozone countries would default.

January Barometer Helps Pick Winning Stocks

Fundamentals be damned, the stock charts are screaming “be long or be wrong.” The Nasdaq has already hit a 11-year high, the Dow Jones Industrials are at almost a four-year high, and the S&P 500 closed on Thursday (Feb. 23rd) less than one point away from a new 52-week closing high. You’d think with this type of bull-market action that investor sentiment would be getting frothy, but surprisingly bullish sentiment as measured by the American Association of Individual Investors (AAII) dropped last week by 8.9 percentage points – the largest drop in almost three months (Nov. 24^th)! Since markets often climb a “wall of worry,” increasing investor caution suggests that this bull has further to run. 

Based on the “January barometer,” the S&P 500 will finish 2012 in the plus column. Since 1950, whenever the S&P 500 has risen in the month of January – as it did this year by 4.4 percent — the stock index has gone on to experience an up-year 89.5 percent of the time (34 out of 38 instances). Even better, in the 18 times that the S&P 500 has been up by at least 4 percent in January, the stock market has ended the year higher every time (100 percent) with an average gain of 22.6 percent. Lastly, the 8 times that the S&P 500 has been up in January (regardless of magnitude) during a U.S. presidential election year (like 2012), it has ended up for the entire year every time by an average of 15.9 percent. I like these odds, although it says nothing about intra-year volatility which could be quite frightening regardless of where the stock index ends the year.

Another way to use the January barometer is to look at the best-performing industry sectors during January and overweight stocks in those sectors (in 2012, the top three sectors were financials, technology, and materials). Since 1990, the best-performing sectors in January have outperformed the S&P 500 over the following 12 months (i.e., February to January) two-thirds of the time and by 1.4 percentage points (8.0 percent vs. 6.6 percent). Even better, since 1970 an equal weighting in the 10 S&P 500 sub-industries has outperformed the S&P 500 70 percent of the time and by a huge 7.6 percentage points (14.4 percent vs. 6.8 percent).

Below is a list of strong stocks from each of the 10 best-performing S&P 500 sub-industries. For each sub-industry, I chose a stock that met the following critieria:

• Debt-to-capital ratio below 0.50 (except bank stocks)
• Return on assets higher than the peer average
• Total return in January higher than the peer average

Best Stocks From Best-Performing S&P 500 Sub-Industries During January

With Greece bailed out, China cutting the bank reserve ratio for the second time in three months and for only the second time since 2008, the MSCI Asia Pacific Index rising for nine consecutive weeks, the most since 2005, and a risky emerging market like India on the verge of a new bull market of its own, the bullish technicals of the global “risk on” trade appear alive and well for the foreseeable future.

Remember, the emerging markets cracked first last year, foreshadowing the decline in the stock markets of the U.S. and Europe, so their resurgence may foreshadow better times ahead for the developed markets as well. Absent a recession crimping corporate earnings, the S&P 500 is currently the cheapest it has ever been compared to 10-year U.S. Treasuries since records started being kept in 1962.

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