Orlando's Outlook: Early 'January Barometer'—Green light now, speed bump later?
Bottom line The S&P 500 posted a 2.17% nominal gain over the first five trading days of calendar 2013, which is a post-Presidential election year. According to the forecasting prowess of the legendary “January Barometer,” that suggests that equity investors could enjoy strong full-year returns this year. One word of caution, however, is that the upcoming discussions in Washington regarding the debt ceiling, the automatic sequester spending cuts, and the federal government’s continuing spending resolution could very well roil the markets in the short term. But if President Obama and Congress can exit those negotiations with an intelligent compromise on spending reductions, then any near-term equity-market weakness may prove to be an attractive buying opportunity.
January Barometer augurs for a positive year As regular readers of this space recall, we routinely revisit one of the stock market’s most popular rules of thumb—the “January Barometer”—as a traditional beginning-of-the-year forecasting exercise. Historically, as the first five trading days of January go, so goes the entire month; and as the month of January goes, so goes the full year.
Since 1950, Jeffrey and Yale Hirsch at the Stock Trader’s Almanac report that 71% of the time (45 out of 63 observations), the direction of the year—up or down—was the same as that of the first five trading days of January. But when the first five trading days of the year were positive, the stock market also finished the year in positive territory 85% of the time (34 out of 40 instances). Importantly, there have been only six instances in 63 years (9.5% of the time) that a positive start to the New Year ended with a negative full year.
Pretty robust company Over the first five trading days of calendar 2013, the S&P generated price appreciation of 2.17%, starting from a price of 1,426.19 on Dec. 31, 2012 and closing at 1,457.15 on Jan. 8, 2013. By including dividends, the total return over this period was a gain of 2.23%. By historical standards, this five-day rally of 2.17% is more than triple the median gain of 0.65% that the S&P has enjoyed in each year’s first week over the past 63 years.
Moreover, this year’s strong 2.17% start places it solidly within the top quartile of first-week performance over the past 63 years. Looking at those other strong 14 years ahead of 2013 in the standings—in which first-week performance ranged from up 2.2% to up 6.2%—it is important to note that full-year performance for each of those years was positive every single time, with an average full-year gain of 17.8%.
Post election-year returns In addition, 2013 is also a post presidential-election year, which typically means dicey returns for investors. Looking historically at the four-year presidential election cycle, the strongest returns by far are usually recorded in a president’s third (pre-election) year, with the fourth (election) year second best. The first two years of a new president’s term are typically the weakest from the stock market’s perspective, as presidents are inclined to make the tough decisions and administer the bitter medicine early in their four-year term, in the hopes of reaping a rebounding economy and stock market as the president and his party power toward re-election.
Since 1950, there have been 15 post-election years (excluding the current one), and seven of those years produced negative full-year returns, with an average gain for all 15 years of a modest 4.43%. But in six of those 15 instances, the first five trading days of January were positive, generating similarly positive full-year returns in five of those six observations (83%), with an average full-year return of 16.1% for all six years.
Fundamentals still matter
Despite the uncanny accuracy of the “January Barometer’s” crystal ball, the investing reality is that economic and corporate profit fundamentals still matter. The S&P has enjoyed a healthy rally of nearly 10% over the past two months, with the back half of that coming in the form of a sigh of relief from investors after the tax portion of the fiscal-cliff deal came together at year’s end.
Even with that recent surge in stock prices, however, equities are currently trading about 13.6 times this year’s estimated consensus top-down earnings of about $108 per share, on an estimated base of about $101 for the just-completed 2012. Given benchmark 10-year Treasuries currently yielding about 1.90%, and year-over-year core inflation similarly below 2%, we believe that Price/Earnings (P/E) multiple expansion back to normalized levels of 17-18 times profits is possible over the next several years. So stocks are certainly cheap.
But what about that upcoming speed bump?
As contentious as the recent lame-duck fiscal-cliff discussion was between President Obama and Congress regarding tax policy, we fear that the upcoming negotiations over spending have the potential to be epic in their ugliness. The 10-year, $1.2 trillion of automatic sequester spending cuts kick in on March 1, the $16.4 trillion federal debt ceiling has already been triggered and needs to be lifted, and the continuing resolution to fund the federal government expires on March 27.
To be sure, we have no idea how this is all going to be resolved, but we remember what happened during the second half of 2011: the Grand Bargain between President Obama and House Speaker John Boehner fell apart; the federal debt ceiling was triggered; the three rating agencies downgraded U.S. credit; and the Congressional Super Committee was a colossal bust. In response, stocks plunged by 20% over three months’ time, before recovering sharply.
Consequently, our equity chief investment officer, Steve Auth, has discussed the potential for a 5-10% correction over the next few months. But the magnitude of such a correction could actually serve as a much-welcomed wake-up call and force President Obama and Congress to construct a more balanced fiscal-policy agreement. If stocks do, in fact, correct by, say, 10% back to about 12.5 times earnings in coming months, we would view that as an attractive buying opportunity, with the potential for P/E multiple expansion back to 14 times profits next year in our base-case scenario, with a target price back above 1,500. Our bull case combines the return of animal spirits for business and consumer spending—along with the tailwind from the planned rebuilding from Hurricane Sandy—which would boost P/Es back to about 15 times profits, with a record target price for the S&P above 1,600.
We plan to follow up with January Barometer, Part II, in early February, after we have investment returns for the entire month of January, to see what full-year market implications we can draw, and to identify what the top-performing industry sectors may be for the year. But given the positive equity-market signal generated by the early “January Barometer” in a post-election year, if we emerge from the upcoming spending-cliff negotiations with an intelligent compromise in place, then stocks could be poised to enjoy a very constructive year.