A bullish 2023 appears to be in the cards for the stock market, according to a little-known indicator that keys off investor sentiment in January.
The indicator, dubbed by its creators the “January Sentiment Effect,” was introduced in a 2018 study in the International Review of Financial Analysis. It is based on the tendency for a January jump in investor sentiment to have a positive impact on the stock market for the remainder of the year. That’s because more optimistic consumers will tend to increase the equity allocations of their 401(k) and IRA portfolio. And since many make those allocation changes just once a year, in January, the increase in equity allocation at the first of the year will have bullish ripple effects for the next 11 months.
Entitled “The January Sentiment Effect in the U.S. Stock Market,” the study was conducted by Zhongdong Chen of the University of Northern Iowa and Phillip Daves of the University of Tennessee Knoxville.
To test their theory for why the January Sentiment Effect works, the professors focused on the University of Michigan’s Index of Consumer Sentiment (ICS) back to 1978, when monthly values for the index first became available. In those years since then in which the ICS was higher in January than in the preceding December, the stock market produced above-average performance from February through December—and vice versa.
That’s what bodes well for the remainder of 2023. From a reading of 59.7 in December, the ICS jumped to 64.6 in January, according to preliminary numbers from the University of Michigan. That’s one of the bigger monthly changes in ICS’s history—ranking at the 91st percentile among all monthly changes since 1978.
As a further test that consumer sentiment in January is the cause of the “January Sentiment Effect,” the professors repeated their test for each of the other 11 months of the calendar. Unlike for January, they found no correlation between any of those other months’ sentiment changes and the stock market’s returns over the subsequent 11 months. These results increase our confidence that the January-over-December change in consumer sentiment is a helpful indicator.
Note carefully that, even though there is a superficial similarity between the January Barometer and the January Sentiment Effect, the two indicators in fact are quite distinct. The January Barometer is the notion that the stock market’s direction in January predicts the market’s direction over the subsequent 11 months. But, as I’ve pointed out numerous times before, the January Barometer has no statistical significance. Several other months besides January have just as good an “ability,” if not better, to foretell the market’s direction over the subsequent 11 months.
In contrast, the January Sentiment Effect reflects an attribute that January alone possesses.
Since there have been just five years since the professors’ study, we don’t have enough data to conduct a robust real-time test of their results. Of those five years, however, there was just one in which the ICS jumped from December to January. In that year, the stock market’s February-through-December gain was four times larger than the average comparable gain in the other four years.
The bottom line? The fact that January is posed it go down in the history books as an up month for the stock market tells us nothing about the rest of 2023. The fact that the consumer is more upbeat in January than in December tells us a lot.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at email@example.com.