By James Flanagan,
Los Angeles, CA, U.S.A.

mike[at]gannglobal.com
http://www.gannglobal.com/

Bullish investors would likely have rather received a lump of coal in their stockings, given the prevailing lofty level of energy prices, than the uncharacteristically lackluster performance delivered them by the stock market in the waning days of 2005. What made the sour ending so unusual was its defiance of the well-documented normal tendency for stocks to rise in December, particularly near the end of the month. December has historically been the strongest month for stocks, posting a gain over 70% of the time, and the traditional "Santa Claus Rally" has swept the S&P higher in the last 2 weeks of the year over 80% of the time since 1950. The trend has remained so potent for so long that since World War I broke out in 1914 the Dow Jones Industrial Average (DJIA) registered its yearly high 20 times between Christmas and New Year's, on one of the last 6 days of the year. In the period from 1890 to 1913, when railroads were the "blue chips" of the era, the Dow Jones Rail Average or its predecessor, the 20-stock Average, closed at its annual high in the last week of the year 5 times. So blue-chip stocks hit a fresh top for the calendar year in the narrow Dec. 26-31 window over 20% of the time (25 times out of 116).

However, in 2005, most stock indexes topped in early to mid December at their best levels of the bull market that began in October 2002. The venerable Dow, constrained by weakness in component General Motors stock, couldn't even get that far, instead peaking just below its March 2005 top on the day following Thanksgiving. Then things turned negative. The yield curve (spread between long- and short-term interest rates) inverted after Christmas, with the yield on 2-year Treasury Notes exceeding the rate for 10-year Treasury Bonds. Yield curve inversions have preceded the last 4 U.S. recessions. Blue chip stocks, as measured by the Dow and S&P 500, sagged almost 2% by year-end to finish December at their respective lows for the month. But 2006 ushered in an explosive rally when minutes released from the Federal Reserve's last meeting suggested that the current round of credit tightenings initiated by the Fed in June 2004 might be nearing completion. The yield curve steepened back into positive territory and investors rejoiced. Already, after just 2 trading sessions, the S&P 500 and S&P 400 MidCap averages recouped all their losses from last month's closing highs with most other indexes not far behind.

A multi-day cumulative decline in the Dow of greater than 1% through the end of the year (meaning a new closing low for the move on the final day), like we experienced in 2005, is so rare that it never happened before 1966. In 1967 stocks burst out of the gate immediately and the Dow rose 9 days in a row propelled by - you guessed it - favorable interest-rate sentiment. On January 26, 1967, banks cut the prime rate for the first time since 1960. We decided to take look back at stock performance in January following all multi-day cumulative declines in the DJIA of greater than 1% lasting through the end of December to see if this year's renewed upbeat tone figures to hold up.

1966-67: After a major low in October and subsequent rally, the Dow Industrials slip 4.27% through the last day of December, then jump 8.12% in January.  The S&P climbs 7.81%.

1978-79: A much smaller 1.35% year-end decline leads to a January gain of 4.25% in the DJIA and 3.97% in the S&P. The NASDAQ outdoes them both, rising 6.65%.

1982-83: December's decline: 2.24%. The NASDAQ (+6.86%) beats both the Dow and S&P, with respective gains of 2.79% and 3.31%, by a 2-to-1 margin.

1986-87: A 3.05% dip in December gives way to a full-fledged buying panic.  The Dow sets a record with 13 consecutive up days to start the year and ends January 13.82% higher. The S&P and NASDAQ skyrocket 13.18% and 12.54%, respectively.

1993-94: December's fall (-1.06%) and January's rise in the S&P (+3.25%) and NASDAQ (+3.05%) are relatively anemic, but the DJIA steals the show with a 5.97% surge.

1996-97: Fairly routine. Dow -1.72% in December, but +5.66% in January; S&P+6.13%, NASDAQ +6.88%.

1998-99: Amid Dot-com mania the DJIA falls 1.5%, then rebounds a mere 1.93%.  S&P +4.1%, but NASDAQ's +14.3% eclipses even the 1987 market.

As you can see, history tells us that the bulls appear to still have room to run this month based on past market response in the aftermath of late-December weakness. Two days into 2006, the DJIA is up 1-1/2% and the S&P 2%. On the heels of a conclusion to the year like we just experienced, January's average gain in blue-chip stocks amounts to a healthy 6%. Generally, the bigger the slide into year-end, the better. December declines under 1% were omitted, as is a mere single-day drop of just over 1% in the last session of 2001, which led to a further 1% January loss in the bear market year of 2002.

The search for trading patterns that surface around the beginning of the year seems to draw habitual focus from Wall Street pundits. Not all of those discovered have stood the test of time. Let's examine how well some of the most notable ones have fared.

The "January Effect" refers to the propensity for small-company stocks to lead the bullish charge very early in the year. In the past, January has been the second best-performing month in the market. Tax-loss selling in advance of the New Year was often proposed as a possible explanation.  No one ever explained why the effect materialized just as strongly in many countries that don't tax capital gains. The phenomenon was so pronounced and reliable that it started to attract widespread attention in academia.  In the late 1980s, a couple of college professors even wrote a book called The Incredible January Effect. 

By 1994, small-cap (small capitalization, based on market value of outstanding shares) stocks began a streak of 6 straight years of underperformance relative to their larger counterparts. The Russell 2000, the best-known small-cap index, actually fell in 7 of the last 11 Januarys (1995-2005), underperforming in 5 of the 7 losing years. The Russell managed to both gain and beat the blue chips in only 2 of the last 12 years (2001 and 2004). So far this year, the Russell 2000 is up 2.4%.

Another aspect of the January Effect is the tendency for last year's beaten-down stocks to shine early in the year at the expense of former winners. So-called "window dressing" by portfolio managers anxious to shed unsightly losers before presenting their year-end reports to clients, as well as a rebound from tax-loss selling has been postulated. The recent record is mixed. In the first week of 1999, cyclical stocks (economically-sensitive industrial companies like Alcoa, GM, Caterpillar, Dupont and USX) roared, outgaining more popular consumer stocks by a ratio of 5-to-1 after a flat 1998. But the red-hot NASDAQ, fresh off a record 1998, picked up where it left off, trouncing the Dow with 5 consecutive new records and a 6.9% weekly gain. Value stocks held up better than growth stocks amid the market's slide in week 1 of 2000, following an unprecedented massive disparity in favor of growth in 1999 as a whole, a year in which the tech-heavy NASDAQ rocketed a mind-blowing 85.6%. But the NASDAQ collapsed beginning in spring 2000, and lost even more ground to the suddenly less unappealing Dow as 2001 kicked off. At the outset of 2002, though, the beaten-down NASDAQ rebounded with far greater vigor than the Dow or S&P.

Will last year's laggards step to the fore in early 2006? Not if the action on Tuesday, January 3 provides any indication. General Motors continued its plunge while hot stocks like Apple, Google and energy companies, thanks to a $2 spike in crude oil, surged.

As January goes, so goes the market for the rest of the year, or so the theory goes. And proponents of the "early warning system" claim to foretell January's direction from its first 5 trading days. Alas, the first 5 days are part of the month and, when factored out, exhibit little if any discernable effect on the remainder. The January Barometer, however, although seemingly susceptible to the same sort of argument, actually boasts a better track record than most human prognosticators. Seventy-five per cent of the time, a winning January foreshadows an up year. But a down month brings further losses in over 60% of instances. Bull market climaxes, significant bear market rally highs and tops leading to prolonged bull market corrections often arrive in January or at the tail end of December. Such events are probably best evaluated on a case-by-case basis.

At one time, secondary stocks could be counted on to invariably rise on the last trading day of the year. What money manager, whose compensation typically depends on performance and assets under management at year-end, would want to cut into profits by selling at the last minute and perhaps knocking down his stocks' prices? The NASDAQ Composite, once a pretty good proxy for small stocks before rapidly growing big technology companies came to increasingly dominate the index in the 1990s, climbed on the last trading day in every year of its existence from 1971 through 1999, 29 years in a row. Since 2000, it's fallen 6 straight times. Traders started aggressively bidding up premiums on futures contracts for the Russell 2000 going into the last day each year so that even a relatively robust gain in the underlying index would no longer guarantee a profit. The Russell 2000, along with the S&P 400 MidCap and S&P 600 SmallCap indexes have also fallen to end every year since 2000, save for nominal gains on the last day of 2002. It would seem that readily identifiable seasonal anomalies around the turn of the year are on borrowed time as soon as they draw wide notice.

There's little evidence that concern applies to the market's predilection to shake off year-end weakness in January though, and, in any event, plenty of reasons exist to remain bullish. In a recent article, we explored historical stock market performance in the aftermath of 14 separate October lows.  The S&P bottomed on October 13, 2005. Thus far, both the duration and magnitude of the prevailing leg up remain well short of historic norms, leaving plenty of upside potential. We found that post-Thanksgiving ennui like we just experienced is fairly typical following initial thrusts off October lows, but the sluggishness almost never persists beyond early January. The entire advance since 2002 is still rather modest by past bull market standards and, as its reaction to the Fed news demonstrates, the market could be poised to leap like a coiled spring on any unexpected good news after the Dow stayed mired in a tight 10% trading range throughout 2005. This stock market displays much in common with the largely analogous markets of 1945-46 and 1985-86, including limited corrections of less than 8%, as witnessed in April and October of last year. Given the accompanying bullish fundamentals now in place (a stronger bond market, energy prices off their highs), we expect a continued strong advance before a final top or larger corrective decline.

James Flanagan is a well known specialist in the field of financial market forecasting and analysis. Using a proprietary, complete database of price history and the methods of W.D. Gann, he has been publishing his forecasts and investment research since 1990 (Past Present Futures newsletter). James oversees all of the research for the Financial, Stock, and Commodity Markets at Gann Global Financial. You can visit his website: http://www.gannglobal.com

Published - January 2006