January Effect

February 15, 2003

When last months newsletter was penned (rather typed) in mid-January, the Dow stood at around 8,700. Just last Thursday the Dow was down 13% from those levels. The market has since rebounded a bit, but is still off around 10% in the last four weeks.

For the entire month of January, the Dow fell just 3.3%. The discrepancy between the month of January's returns and January 15th through February 15th period returns was largely because early January was quite strong for the market.

In the first two weeks of the year the Dow ran up 6%. This excited everyone because of something called the January Effect, a market theory that basically says how goes January, so goes the rest of the year.

According to some January Effect proponents, January has predicted the year's returns over 90% of the time. This is why many investors are nervous these days. January ended down. If the January Effect is true, this means we have a 90% chance of losing money this year in the market.

Confusing matters is another market "fact", the one that says the market almost never goes down 4 years in a row. Since the market was down in 2000, 2001, and 2002, 2003 is surely to be an up year. In fact the last time the market was down four years in a row was during the great depression, a period of major economic problems following massive stock market insanity. Currently we are in a period of minor economic problems following massive stock market insanity - a much better situation.

There are many more ways to predict future market returns, each more absurd than the next. Hemlines were once considered excellent market predictors (they are on the way up this year, in case you are wondering), who won the Superbowl, and even the state of CNBC's Maria Bartiromo's hair.

Rather then take the time to discredit each of these interesting statistical anomalies, lets focus on what "works" in investment forecasting - the facts tend to predict the future.

With so much financial data coming at you, it sometimes clouds what investing really is. All you are doing when you invest is buying an asset that has some future (sometimes unknown, sometimes quite known) earnings power.

How well you do, broadly speaking, is based largely on how accurately you can assess that assets ability to deliver those earnings returns into the future, and paying a reasonable price for it. 

In the shorter term, the market can be almost completely insane. Investors and traders talking about volume, past patterns, facts like how often the market does this or that, strength, etc. In the long haul none of that matters. All that matters is how much you paid.

Sometimes the market over reacts on the up and the downside. This can hurt investor's returns. In early 2000 stocks were expensive. It will take quite some time for investors who got in then to "earn" there way out of a hole.

Currently the market is falling. It is unwinding past wrongs. Usually past wrongs do not take that long to unwind, but the last "wrong" was so long in the making that this time is a little different. Could the market go down a 4th year? Certainly. The market can go down 10 years in a row. There are no rules.

There is no difference if the market goes down 5% a year for many years or 50% all at once. What ultimately maters is how much it fell and what it now costs to buy those future revenue streams.

Currently these future earnings cost quite a bit less than a few years ago. Does that mean that stocks can't get "cheaper" (fall more in price)? Absolutely not. Stocks could just as easily fall 25% more in price as they could rise 25%, although we would argue the chance of them falling more declines the more they have fallen.

All that really matters is if are you paying a reasonable price now. Sure the market may fall 20% and investors who come into the market after that fall are getting a lower price than today, but they just as likely may miss the market going up 20% and have to get in at a higher price. 

As long as the basic price now is reasonable, you are going to do fine in the longer term. And since you can shift extra money into stocks if they fall much further, or move some money out of they rise sharply, you can benefit a bit by rebalancing during these wild swings.

So ignore all these magic "predictors". At these levels you can own stocks. With the MAXadivosr newsletter we pick good funds based largely on where the best opportunities and the lowest prices exist in the market and we build reasonable risk model portfolios out of them. Sure these portfolios will lose money if the market falls another 20%, but over the long haul they will beat the returns investing in money markets, t-bills, and CDs. 

These portfolios will do this because prices of stocks are not so out of whack as to make it impossible, not because of some past pattern, theory, technique, or anomaly says so. 

One thing we know for sure - and you don't have to have a crystal ball to predict this one - either the January effect will fail this year, or the market will have to go down for the 4th year in a row. One has to give, because they both can't happen.