What January Effect?

The expected New Year market boom has been pretty blah so far --and that could be bad news for the rest of 2005

By Marcia Vickers

Though January is often a lousy month -- bad weather, post-holiday blues, abandoned resolutions -- it's usually the best month for stocks. That's largely due to the "January effect" as folks pour yearend bonuses into the market and allocate new money to retirement plans and the like, causing the market to rally.

This year, though, it seems like a bad joke. In fact, you might call the 2005 version the "rubber chicken effect." The Standard & Poor's 500-stock index is down 1.3% so far in 2005, the Dow Jones industrial average has sunk 1.4%, and the Nasdaq has lost about 2%.


  Market mavens aren't amused. Some say such a weak start could portend a flat to down year -- especially if the entire month ends in negative turf. Says Jeffrey Hirsch, the editor of the Stock Trader's Almanac and an expert in how stocks react seasonally: "If January can't mount a gain, any further advance we expected for 2005 is probably dead in the water."

He points out that every down January on the S&P since 1950 preceded a new or extended bear market or a flat market. But he emphasizes that "I'm holding out for the entire month -- it's still a bit too early to tell."

Long-time observer Hirsch has seen enough stock action over the years to know that Mr. Market could play another joke and stage a rebound in the second half of January or in February. And that's what Richard McCabe, chief market analyst at Merrill Lynch, thinks will happen. He says he fully expected the recent weakness, since the major indexes were overbought -- that is, many more investors bought stocks rather than sold them. He's looking for the market to rebound slightly in the near future.


  There's a caveat, however: If the rally is somewhat weak, the year isn't looking so good. "We think 2005 will be a transitional or topping year in some manner on the post-2002 bull market," says McCabe, who points out that current bull market has lasted 2.25 years, perilously close to the 2.5 year average bull run. He thinks investors need to become less optimistic about stocks and stocks need to weaken a bit for there to be a "new sustained phase of market strength."

Why have stocks foundered since the first of the year? Partially because investors already had their fun by taking profits from the market's sizable post-election run-up, says Alexander Paris, chief financial analyst at Barrington Research in Chicago. From Nov. 2 to Dec. 31, both the S&P and Dow gained about 7%, with the Nasdaq rising 10%. Others, like options maven Bernie Schaeffer, point to the slew of earnings warnings in early January from the likes of Home Depot (HD ), Verizon Communications (VZ ), and General Motors (GM ).

Some strategists say investors are reacting to a macro situation that remains tenuous: slower earnings growth, higher interest rates, rising inflation, and pricey oil. According to Trim Tabs, investors poured just $1.2 billion into equity funds in the first two weeks of January, compared to $8.8 billion in the same period last year.


  Meantime, those decelerating earnings may be spooking investors. Though year-over-year profits for the S&P 500 grew 20% in 2004, this year analysts predict they'll grow only around 10%. That would be a huge shift in market psychology and behavior.

And "if we are correct and the profits cycle continues to slow in 2005, higher-quality stocks should outperform lower quality ones," says Richard Bernstein, chief quantitative strategist at Merrill Lynch. He points out that utilities, consumer staples, and financials are the only sectors forecasted to have higher profits this year.

Enough trading days are still left for January to reverse course and end on an up note. And a sour January doesn't absolutely guarantee that the year will be bad. But it could be a hint that 2005 may offer leaner pickings when it comes to stocks.

Vickers is a senior writer for BusinessWeek in New York

Edited by Beth Belton

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