Chances are if you have read anything recently about the stock market, you heard about something called the January Barometer.  The latter was identified by the Stock Trader's Almanac and can be summarized in the following maxim: "As the S&P 500 goes in January, so goes the year."

That trite statement packs quite a probabilistic punch when one takes into account that the barometer has a 75.8% accuracy ratio since 1950.  That includes years when the S&P 500 was up or down less than 5%, which the Stock Trader's Almanac deems to be a "flat-year error."  If only major errors since 1950 are included, the accuracy ratio jumps to 88.7%.

This January the S&P 500 increased 5.0%.  That was its best January showing since 1997 when the S&P 500 ended up gaining 31.0% for the year (ah, the good old days).

Might we see a similarly, euphoric move in 2013?  Anything is possible when allowing for the prospect of political peace on earth, central bank money printing, and a "great rotation" out of bonds and into stocks. 

Still, it would be entirely imprudent from a risk management standpoint to bank on the January Barometer.  Remember, it doesn't have a 100% accuracy rate.

January Takeaways

We saw and learned a lot in January.  Our top 10 takeaways, divided in groups of five, are summarized below. 

The first grouping reflects the driving forces in January.  The second grouping calls attention to developments in January that could shake the January Barometer in coming months. 

• The stock market was greatly relieved that the full force of going over the fiscal cliff was avoided with the eleventh-hour agreement on tax rates.
• The Federal Reserve isn't going to be pulling back on its accommodative policy anytime soon.
• Real economic growth in developed economies is either lousy or negative, but the stock market is discounting much better days ahead.
• Earnings growth has been better than expected, but revenue growth remains weak and indicative of activity in the real economy.
• Investors have grown less fearful about negative outcomes, prompting some asset reallocation out of bonds and into stocks.
  
  
• Partisan politics continue in Washington, which is setting up for a divisive battle over the debt ceiling, spending cuts, and entitlement reform.
• The Middle East remains a boiling pot of political, religious, and social divisions.
• Japan has embraced a policy of reckless currency abandon to reflate its economy.
• The use of margin debt is near a 5-year high and the level of bullish investor sentiment (48.0%) is nine percentage points above its long-term average.
• The pinch of the payroll tax hike and rising gas prices are showing up in consumer confidence measures.

Better Days Ahead

The stock market didn't spend too much time in January dwelling on negative thoughts.  If anything, the message of the stock market's behavior in January was that it is discounting better days ahead.

That upbeat outlook manifested itself in the leadership of the Dow Jones Transportation Average, the Philadelphia Semiconductor Index, the small and mid cap stocks, most cyclical sectors, and oil prices.

It came through on more than a few occasions, too, from management comments during earnings calls to discuss results for the December quarter.  There were many warnings about the March quarter, but another overarching view was that companies are expecting better things in the second half of the year.

Time will tell, but most market participants seemed to buy into that line of thinking, which is standard fare.  Most companies always see things being better six months down the road. 

For illustrative purposes, we have included a January performance table below.

Something that is sure to stand out is the underperformance of the Nasdaq 100 and the information technology sector.  Apple (AAPL), which dropped 14.4% in January, gets much of the blame for that.  On another level, its struggles offer a sobering reminder that selling interest can accelerate and feed on itself when the tide of bullish sentiment turns.

That is a point one shouldn't forget in a broader context as the market trades with an air of insouciance about the outlook. 

February's Cold Shoulder 

The month of February began on a banner note.  Following a perfectly imperfect employment report for the month of January, the S&P 500 jumped 1.0% and stands just 4.2% from the all-time high it reached in October 2007.

The report was perfect for the stock market in that it did everything to support the notion that the Fed isn't going to be abandoning its current policy stance anytime soon.  The 7.9% unemployment rate, however, exposed the imperfections in the real economy that the Fed has been unable to correct and that the liquidity-driven stock market continues to overlook.

The dichotomy between the financial markets and the real economy has been stunning.  One seems destined to catch up with the other, but which one is the $3.0 tln (and counting) question.  We can tell though which answer the stock market is leaning toward at the moment.

So, what do we know about February other than it is a typically cold month that produces warm Valentine's Day wishes?

According to the Stock Trader's Almanac, February ranks as the second worst-performing month for the S&P 500 dating back to 1950 with a total percentage change of -7.4% and an average change of -0.1%.  The average change over the last 14 years has been -1.5%.

February is the "weak link," the Stock Trader's Almanac says, in the best six-month period of November to April for the market.  Still, since 1950, February has shown more up moves (34) than down moves (29).  The wrinkle is that the down moves have outweighed the up moves, thereby producing an average decline for the month since 1950.

The weakness can be explained away in part by the historical strength of January that lends itself to profit taking in February.  That setup is certainly intact this year, yet Friday's rally gave the month of February some cushion to avoid adding to the column of down moves.

What It All Means

One has to respect the price action and the performance of the market, but it is also important not to get blinded by the light of complacency.

There are some realistic spoilers lurking in the shadows, including the dramatic weakening of the yen, the adverse impact of rising gas prices and the higher payroll tax, political uncertainty in the eurozone, the impending debate about the debt ceiling, spending cuts, and entitlement reform in Washington, and the rising level of speculation and bullish sentiment in the stock market.

History has shown that the stock market can remain in an overbought condition a lot longer than seems practical, and with the wind of Fed support at its back, that could prove true this time around.

January was a great month and provided an encouraging start to the year.  The rally, however, didn't sway us from our view that investors should maintain a balanced mix of cyclical and countercyclical sectors in the equity portion of their investment portfolio.

That mix allows for participation in feel-good moves like the one we saw in January and will help to mitigate losses in the event the tide of bullish sentiment turns.

The January Barometer is a hopeful indicator that good things lie ahead for the stock market.  To be sure, though, it is not a guarantee.

--Patrick J. O'Hare, Briefing.com