It's a perplexing stock market, and January's outstanding market sectors say it all.
The top three: Health care, telecommunications and materials--not kindred spirits that usually rise together.
After all, health care is a defensive haven for investors worried about slowing economic growth, and the materials sector is the far opposite. Materials tend to do best amid strong growth.
But rather than try to dissect the message, and do the number crunching that goes with stock picking, Standard & Poor's 500 sector strategist Sam Stovall said he has identified a shortcut that is fairly reliable.
He has tracked sectors since 1990 and found that January tends to hold some predicting power. It's not perfect, but more often than not, he said, the three sectors that are strongest in January give investors the best returns for a 12-month period.
So he lays out a simple investing strategy: Each year in February, identify the three strongest groups of stocks from January, buy them, and hold them for the next 12 months. An investor doing this since 1990 would have had an average advance of 15.4 percent, rather than the 10.2 percent provided simply from the S&P 500 index.
For this year, that would mean investing in materials, which climbed 4.5 percent in January; health care, which was up 3 percent; and telecommunications, which rose 3.1 percent. That compares with a 1.4 percent climb for the benchmark S&P 500.
All three sectors are available to investors via exchange-traded funds.
In the broader market, January has for some time been identified as a harbinger for the year. Based on research since 1945, the Stock Trader's Almanac has concluded that when the S&P 500 climbed in January, the year tends to follow January's lead--climbing 85 percent of the time. The average advance after a positive January: 11.8 percent compared with the 9 percent return for the S&P 500 for all the years.
Wall Street likes to search for simple indicators to predict the future. Some are flimsy. For example, one belief holds that if one of the teams from the original National Football League wins the Super Bowl, the year turns out good for stockholders. In other words, although it's not scientific, stocks should climb this year because the Indianapolis Colts won last Sunday's game.
The January effect, however, is predicated on somewhat firmer ground: Investors tend to have cash to invest as they go into the new year because they have sold stocks at the end of the previous year for tax purposes. With the advent of a new year, they tend to study extensively the fundamentals that might drive the economy and stocks, and then try to position their portfolios for the coming months. Investing theory holds that all this thinking is reflected in the stock market, through what's called "efficient market theory."
Stovall believes that in January, just after the experts have pored over their portfolios, the thinking might be freshest--perhaps more revealing than during the year when investors react to short-term stock market activity.
"So investors who aren't likely to stay up to the wee hours of the morning analyzing stocks could simply be opportunistic, leveraging the efforts put in by others," Stovall said.
Of course, he doesn't suggest allocating an entire portfolio toward only the winning sectors.
"January sends a signal, but it is not foolproof," Stovall said. The strategy has been successful in three out of four years.
For example, in 2000--the year the technology bubble exploded--the strategy worked. It would have helped investors stay clear of overly pricey technology stocks positioned to crash.
The top three sectors in January were energy, health care and utilities, as investors positioned portfolios away from technology stocks that had historically high valuations. Of 10 market sectors, technology ranked seventh based on returns for the month. And by the end of 12 months, January's winners had climbed 17.6 percent while technology stocks fell about 39 percent.
In 2001, however, the strategy was a failure.
Investors made the mistake in January 2001 of thinking the worst was over for technology and telecommunications stocks. Earnings reports were not yet reflecting the erosion in profits that would show up later in 2001, and the Federal Reserve was starting the first of 13 interest rate cuts.
Investors thought those cuts would cause the market to start climbing, because interest rate cuts tend to send the market higher over the next six months, said Stovall. But in 2001, "it was one of the few times it was not a smart bet."
By the end of the 12-month period, the top three sectors from January 2001--telecommunications, technology and consumer discretionary shares--declined 26 percent while the S&P 500 dropped about 17 percent. Investors suffered as the market came to grips with the euphoria that had made the market vulnerable at the end of the '90s.
Technology was the worst, falling 36.4 percent, telecom was down 30.7 percent and consumer discretionary stocks were down 11 percent.
This year, Stovall said, January's market signaled that materials, health care and telecommunications could outperform the rest of the market.
Yet fundamental analysis by some analysts challenges that signal.
Health care and telecommunications are understandable, Stovall said, because the two sectors are expected to show stronger earnings growth than other sectors. That could make the sectors attractive at a time when profit growth in the market in general is slowing.
But materials stocks are a contrarian play. After earnings growth of 42 percent for the last quarter of 2006, profits in materials are expected to climb only 7.3 percent for 2007, Stovall said.
He thinks the popularity of the cycle in January might have been driven by the belief that perhaps analysts cut expectations too much for materials, and profits could consequently exceed the prevailing view. When sectors surprise investors favorably, stocks tend to rise. And when they deliver negative surprises, stocks fall.
Based on fundamental analysis alone, however, S&P analysts are not embracing materials. Of the three sectors popular with investors in January, the analysts are only recommending that investors overweight health care.
Gail MarksJarvis is a Your Money columnist.Copyright © 2015, Los Angeles Times