With This ‘January Barometer,’ More Fodder for Bulls

The year is one-twelfth over. Have you made any money yet?

If you have a diversified investment portfolio, the answer probably is . . . yes and no. Which is exactly how many people continue to think that 1998, overall, will turn out: a mixed year for financial markets and a tougher year in general to make good money than has been the case for at least three years.

Yet despite considerable volatility in the U.S. stock market in January--with Asia, the White House and fourth-quarter corporate earnings reports all vying for attention--the average general U.S. stock mutual fund was down less than 0.1% from Dec. 31 through last Thursday, according to fund tracker Lipper Analytical.

Given the extent of the month’s surprises (does anyone even remember Indonesia’s currency meltdown since Monica Lewinsky became part of the national consciousness?) January easily could have been a much rougher month for Wall Street.

The market’s bulls are taking great comfort from January’s stock market performance--in particular, the 1% rise in the blue-chip Standard & Poor’s 500 index. That may not sound like much, but any rise at all in the S&P; 500 in January is viewed as a good sign, because January’s market trend has a long history of foretelling the trend for the full year.

The “January barometer,” as it’s known, has an 81% accuracy rate since 1950: In all but nine years since then, an S&P; gain in January has foretold a gain for the year and an S&P; decline in January has foretold a decline for the year.

No one can say exactly why this indicator works so well, but many Wall Street pros believe that, after year-end transactions (sales to take gains or losses for tax purposes, for example) are completed by Dec. 31, investors show their true sentiment about the stock market come January.

Obviously, however, investors can’t know in January exactly what external shocks will hit the market in the new year. The January barometer was wrong as recently as 1994: The S&P; rose 3.3% that January, but it fell 1.5% for the full year as the Federal Reserve Board doubled short-term interest rates.

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Still, the barometer’s long-term accuracy rate suggests there is good reason to pay attention to the direction markets take in January.

With that in mind, what follows is a capsulized review of the performance of key investment sectors so far this year:

* U.S. blue-chip stocks. The Dow Jones industrial average finished January at 7,906.50, for a tiny net loss of 1.75 points for the month--even as the broader S&P; 500 index rose and reached a record high last Thursday before easing slightly on Friday.

Could the S&P; index’s record high have been a fluke--or, perhaps, the last gasp of the great 1990s bull market?

Unlikely, argues PaineWebber Group’s chief investment strategist, Edward Kerschner. He concedes that the market has plenty to worry about (Asia, President Clinton’s troubles, rising labor costs, etc.). But the bottom line is the bottom line, he says: Big U.S. companies continue to post earnings growth, albeit at a slower pace than the double-digit growth of recent years.

With two-thirds of the companies in the S&P; 500 having reported fourth-quarter profits as of Thursday, earnings tracker First Call now estimates that the average blue-chip company will show an earnings gain of 9.2% in the fourth quarter.

This year, the depressing effects of East Asia’s economic slump will certainly pull down full-year earnings growth for the S&P; companies, Kerschner says. But he still expects annual profit growth to average 6% to 7% over the next two years, assuming the U.S. economy remains healthy.

And that is enough, he says, to make him believe that “the next 1,000-point move in the Dow Jones industrial average is likely to be up,” not down.

What about blue-chip stocks’ historically high prices relative to their per-share earnings? Those price-to-earnings ratios should be high, Kerschner and other bulls argue, as long as inflation and interest rates remain subdued.

And while 1,000 points on the Dow still sounds like a lot, it amounts to a 12.6% rise from current levels. If that’s what the Dow achieves over the next two years, and Kerschner is correct about blue-chip companies’ earnings growth, what he’s essentially arguing is that stocks will simply rise in tandem with slower earnings gains.

But that’s still a bull market and good enough reason to stay invested, Kerschner says.

The bear case, on the other hand, is that U.S. blue chips are historically overvalued and will face much greater profit pressures because of Asia and rising U.S. labor costs. The companies and Wall Street are trying desperately to divert investors’ attention from those risks, the bears say.

“In an aging bull market, those with a vested interest will do everything within their power to keep the momentum going,” warns James Stack, publisher of the InvesTech market letter in Whitefish, Mont., and a longtime bear.

* U.S. smaller stocks. The average small-stock mutual fund was down 1.5% for January, through last Thursday, according to Lippper. And the Russell 2,000 index of smaller stocks fell 1.6% for the month, while the S&P; rose.

For smaller stocks--which typically means anything other than the top 500 or so major blue-chip multinational issues--this year is beginning the way last year ended.

The average small-stock fund gained 20.6% last year, far behind the 34% return of the S&P; 500.

Investors’ relative disinterest in smaller stocks reflects, in part, a

concern about liquidity, analysts say: If you’re worried about being able to exit the market quickly should some other disaster strike this year, you’d rather own an easily salable stock like General Electric than a little-known issue.

But as investors shy away from the stocks of thousands of smaller companies, many of those shares are becoming bargains, small-stock proponents argue. They believe it makes more sense for long-term investors to be pushing dollars into smaller stocks now than chasing pricey blue chips.

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Nonetheless, January’s trend wasn’t encouraging for investors expecting smaller stocks to beat blue chips in ‘98, says Claudia Mott, small-stock analyst at Prudential Securities in New York.

Wall Street used to count on the “January effect,” the term coined to note that smaller stocks often rallied sharply in January after year-end tax-related selling.

But with the Russell 2,000 index down last month, the January effect was a no-show once again. And “the lack of a January effect is usually a bad omen for the remainder of the year” for smaller stocks’ performance relative to big stocks, Mott concedes.

* U.S. bonds. Bond yields ended January below their levels of Dec. 31 but above their two-decade lows set at mid-month. The yield on the benchmark 30-year Treasury bond, for example, finished Friday at 5.79%, versus 5.92% on Dec. 31 and 5.69% at its low on Jan. 12.

As the month ended, Fed chief Alan Greenspan was publicly sounding more and more conciliatory about interest rates--meaning he has no intention of tightening credit any time soon.

He didn’t say precisely that, of course, but in his Capitol Hill testimony on the economy late last week, “he implicitly endorsed our view that the Fed won’t raise rates this year, but might actually lower them instead,” says Edward Yardeni, economist at Deutsche Morgan Grenfell in New York and a veteran Fed watcher.

If Yardeni is correct, then the outlook for bonds may still be quite rosy. In fact, if you believe that Asia’s mess is only beginning to hurt U.S. companies’ sales and earnings, then disappointment on that front may be much worse come spring--and interest rates could be falling again by then.

“I still expect bonds to outperform stocks this year,” Yardeni says.

Tom Petruno can be reached at tom.petruno@latimes.com