There is an old stock market adage that what happens to shares in January can determine the direction of the market for the rest of the year.
The so-called January barometer says: “As January goes, so goes the full year.” It is reckoned to be accurate about 75 per cent of the time, which is quite a high success rate. But how is that possible? How can something that happens in the first 31 days of a calendar year have such a profound effect for the remaining 334 days?
Firstly, stock markets tend to rise, anyway. It is an underlying feature of capitalism, which is simply nothing more than putting capital to work to generate a decent return on the money. Just think about how we, as individuals, shop around for deposit accounts that pay a better rate of interest. Or how we might withdraw money from a savings account to buy Treasuries because the latter offers a better return. Companies do something similar.
Secondly, companies will continually review projects to determine if they are getting the most bang for their buck. It is that desire to make increasingly larger profits that can drive share prices higher. And as profits increase across the board, it is not unreasonable for markets to rise, too. So, a strong finish to a calendar year may not be so much a result of a strong January but rather that it was always going to finish strongly, anyway. It just happens that January was a good month for shares, too.
Now, consider the years when January was a lousy month for shares. If the adage holds, then it would stand to reason that it would be a rubbish year for shares. But that doesn’t seem to be the case. In the years when shares performed badly in January, the stock market still ended the year higher 50 per cent of the time.
Perhaps the conclusion that we can arrive at is that the January barometer is nothing more than confirmation bias that makes us look smarter than we really are. In other words, the stock market generally rises. So, a good performance in January merely helps to confirm what we already know. It simply makes us feel better about ourselves.
That raises an interesting question about what exactly is the price of a share. Who or what determines the right price of a share? How, for example, is it possible that a share can be worth $1 today and fall or rise by 20 per cent the very next day when nothing much appears to have changed? It can sometimes be perplexing if not unnerving for investors to watch their investment lose a fifth of their value. Of course, it can be exhilarating when the value jumps.
Thing is, a share price is the product of its earnings (earnings per share) and how much the market is prepared to pay for those earnings (price-to-earnings ratio). The first part is easily defined. It is simply the profit that a company makes divided by the number of shares outstanding. Nothing could be simpler. The second part is a bit more nuanced, which is why the stock market is such a fascinating place.
Consider what happens when prevailing interest rates are high. Why would we want to buy a risk asset such as shares when we can get a good return on a risk-free investment such as cash? When that happens, share prices can drop regardless of how attractive earnings are. Now, think about what happens when geopolitical tensions are on the rise. What can be safer than a bar of gold? Consequently, gold prices could rise at the expense of share prices.
The point is that share prices can fall or rise for all sorts of reasons; a drop in price isn’t always because of a deterioration in company earnings. In fact, the share price often has very little to do with a company’s earnings per share. The harsh reality is that we can’t ever control the price of a share. But we do have total control over the companies we invest in.
So, instead of worrying about share prices this year, focus on the earnings per share. If you haven’t already made a new year resolution, here’s one to consider – control the things you can control, ignore the things you can’t. Have a great 2024.
Note: An earlier version of this article appeared in The Business Times.
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Disclosure: David Kuo does not own shares in any of the companies mentioned.
