A Sell Signal Worth Considering

According to Wall Street lore as the first five days of January go, so goes the month. And in case you've forgotten, the first five trading days of 2014 were down. So, in keeping with tradition, the S&P 500 also finished lower for the first month of the year. Check.

Next up is the old saw, "As January goes, so goes the year." Thus it is discouraging to realize that all the major stock market indices closed with losses for the month. Uh oh.

This concept is also referred to by some analysts as the January Effect. No, not that January Effect, which features the tendency for beaten-down small capsto outperform in the first month of the New Year. This so-called "rule" looks at whether or not a decline in January has any predictive value for the rest of the year.

Spoiler alert: Unfortunately, it does.

January is Usually Such Fun

Everybody on the planet knows that January is one of the best months of the year for the stock market. Therefore a positive January tends to be a self-fulfilling prophecy. You see, since 1950 the S&P (NYSE:SPY) has finished higher during the month of January 63 percent of the time.

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Perhaps this is due to new money coming into the market,from pension plans and the like,to start the year. Maybe it is because Mom and Pop want to get that IRA money invested early. Or perhaps Januarys tend to finish higher simply becausethe market itself tends to move higher during the vast majority of calendar years.

Regardless of the reason why, traders have a tendency to come into a new calendar year looking to make some money.

Say it Ain't so

The theory is that, if the market fails to rally during what is traditionally a bullish period, then the negativity tends to persist for the rest of the year. Sounds unbelievable, right? And how could this possibly be true this year? After all, wasn't 2013 a banner year for stocks?

Unfortunately, when the month of January finishes in the red, it is indeed a sell signal for the remainder of the year -- even if the prior year was strong.

When January is Down, the Rest of the Year is...

Over the past 64 years, the S&P 500 has closed lower for the month of January 25 times. The average loss during those loser Januarys has been 3.9 percent. So it is worth noting that this year's decline of 3.6 percent was actually better than most. However, it is the next part that is a bit worrisome.

Since 1950, when January has been down, the average return for the rest of the year has been... drum roll please... 0.0 percent. Yep, that's right: zero, zilch, nada, squat.

But wait, there's more. While this may not be intuitive, when the stock market has finished higher the year before and January winds up being punk, the market does worse. History shows that the average return in a situation like we're faced with now (when the prior year was up and January was down) has been -2.8 percent.

What's worse is that, during the 46 percent of the time that the ensuing February through December period is down, the average loss during these down years is -14.05 percent. Ughh.

So What's the Takeaway?

The takeaway from this brief history lesson is first, that a bad January does indeed have negative implications for the rest of the year. When January has been down, the market has been down 46 percent of the time. And during those down years, it has been pretty ugly.

The good news is that since 1950, the February-through-December period following negative Januarys only produced losses exceeding 10 percent on five occasions. And three of those took place during secular bear market periods (1974, 2002, and 2008). Therefore, one could argue it is really the overall state of the market that may have more meaning than the result of a single month.

However, the bottom line appears to be that a bad January has led to subpar gains in the stock market. And the key takeaway here is that, armed with this knowledge, investors may want to play the game a bit more cautiously -- and take profits early and often during the rest of 2014.

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