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John Dorfman

John Dorfman: It's a funny January in the market this year

John Dorfman
| Monday, Jan. 22, 2018, 11:00 p.m.

January isn't following its normal pattern this year in the stock market.

Typically, stocks that were beaten up in the prior year spring back to life and show strength. Often, the stocks that did best in the prior year stumble.

Not this year.

Through Jan. 19, last year's biggest winners (the top 10 performing stocks in the Standard & Poor's 500 Index) had returned 8.4 percent, while last year's worst losers (the bottom 10 performers in the index) had inched up only 2.6 percent

For comparison, the S&P 500 had advanced 5.2 percent. All figures are total returns including dividends.

Weirdness

This is weird, because the normal pattern is a logical pattern. Poorly performing stocks get dumped in November and December so that investors can reap deductions on their taxes. Some losers get punished excessively, hence the traditional January Bounce.

Hot stocks — the best performers — aren't likely to be sold in November or December, because who wants to pay capital gains tax sooner than necessary? Sell in December 2017, and you pay tax four months later. Wait until January 2018 to take profits, and you defer paying the tax until April 2019.

This year, the tax-driven January effects should have been stronger than usual, not weaker. After all, everyone knew there was a strong likelihood that Congress would pass a tax cut. That made tax deductions for 2017 more valuable, and increased the incentive to delay selling winners until 2018, when taxes would be lower.

What gives

And yet, the usual thing — the logical thing — didn't happen.

The five biggest winners of 2017 (among the 500 stocks in the index) were NRG Energy Inc. (NRG, up 132 percent), Align Technology Inc. (ALGN, up 131 percent), Vertex Pharmaceuticals Inc. (VRTX, up 103 percent), Wynn Resorts Ltd. (WYNN, up 94 percent) and Boeing Co. (BA, up 89 percent). They are all up this year except for NRG.

The five biggest losers of 2017 were Baker Hughes a GE Co. (BHGE, down 51 percent), Range Resources Corp. (RRC, down 50 percent), Under Armour Inc. (UA and UAA, down 47 percent and 50 percent, respectively) and Scana Corp. (SCG, down 46 percent). All of them are down this year except Baker Hughes.

What gives? That's a complex question, but I think I may have at least part of the answer. The tax cut passed in late 2017 was part of the platform on which Donald Trump ran for president. It's probably fair to say it was one of the three main planks of his platform, along with “the Wall” and the repeal of Obamacare.

Ever since his inauguration, President Trump had been promising a tax cut, and the thought was echoed by many Republicans in Congress. It was, therefore, a widely anticipated tax cut, and the news may have been priced into stocks gradually throughout 2017.

Also, “momentum” has been the strongest-performing investment style in recent months. Using tools such as “relative strength,” momentum investors bet that what has been going up will keep going up.

The vogue for momentum didn't change just because the calendar year did.

The barometer

While we're on the subject of January, let's also look at the so-called January Barometer, which posits that a strong January predicts a good year in the market. Popularized by market pundit Yale Hirsch, the theory is believed by many investors.

Since we are having a strong January now, it would be pleasant to believe that the January Barometer is a reliable instrument.

January is, of course, part of the year it is supposed to predict, so the questions worth asking are: Does January predict the next 11 months? And does the January Barometer do better than a naïve forecasting model?

I've studied the performance of the barometer in every year from 1950 through 2017, a total of 68 years. The indicator has predicted the next 11 months correctly in 69 percent of the cases.

But a naïve forecasting model that always predicts the market will rise in February through December would be right 76 percent of the time.

When the market stumbles in January, that's supposed to be a danger signal. The signal has flashed 27 times since 1950. But only in 41 percent of cases did stocks fall in the ensuing 11 months.

So, enjoy your January gains, investors. Just don't think that they predict what's coming, one way or the other.

Disclosure: For clients with high risk tolerance, I hold put options on Align Technology, Vertex Pharmaceuticals and Wynn Resorts and have sold short shares of NRG Energy. Some of my family members own shares of Boeing. I consider most of these short-term trades rather than long-term investments.

John Dorfman is chairman of Dorfman Value Investments LLC in Newton Upper Falls, Mass., and a syndicated columnist. His firm or clients may own or trade securities discussed in this column. He can be reached at jdorfman@dorfmanvalue.com.

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