Does a Down January Spell Doom?

Barring a huge rally today, the stock market (as measured by the S&P 500) will post January losses for the second year in a row. For many, that's a sign that the bear market could continue unabated until 2010. But is the so-called January effect really that accurate an indicator of things to come?

Market folklore includes quite a few seasonal and event-driven market indicators:

• According to the Super Bowl effect, bulls should cheer on the Arizona Cardinals this week.
• On average, September has been the worst-performing month for stocks, and 2008's market performance was one for the record books -- the S&P fell more than 9%.
• Many believe that investors do best if they "sell in May and go away" -- remaining invested only from November to April. The practice has some historical support, and last year, it would've saved you from substantial losses. But then, you'd still be sitting on fairly big losses by buying stocks last November.
• The old hemline indicator looks to the length of skirts for guidance on the market. I'm not sure how to interpret that one if it's been below freezing for so long that no one wears skirts, long or short.

Finally, the January effect has several interpretations. Some look at the whole month and argue that a bad January means the market will be down for the year. Others believe the direction stocks move in the first five trading days predicts whether stocks will rise or fall for the whole year. And still others focus on small-cap stocks and look for outperformance versus their large-cap counterparts.

As silly as these rules of thumb seem, investors are more likely than ever to grasp at straws during troubled times -- and if enough people believe an indicator, it can become a self-fulfilling prophecy. So rather than simply dismissing the January effect out of hand, let's take a closer look and see whether it's held true lately.

A look at history
The January effect has worked well over the past few years. Markets rose in January during 2006 and 2007, but fell in 2008, corresponding to rises and falls in the overall market. They also fell in 2000 and 2002, during the previous bear market.

But the indicator has also given some false signals. Stocks dropped in January 2005, but the market recovered and rose for another two and a half years before finally succumbing. Stocks also dropped in early 2003, near the end of the tech bust, but ended the year up sharply.

Meanwhile, the January effect has given false positives in the past as well. In 2001, some looked to positive performance as a possible sign that the 2000 downturn would prove to be only a correction. The market would drop for another two years before bottoming.

Who beats the trend?
There's another reason why the January effect doesn't mean that investors are doomed: You don't have to buy the whole market. Even when the overall market was down, some stocks have done well both in January and for the entire year. For instance, look at these companies:

Source: Capital IQ, a division of Standard and Poor's, as of Jan. 29.

Also, other stocks have bucked the downtrend to rise strongly despite performing badly in January 2008. Gilead Sciences (NASDAQ:GILD) and General Mills (NYSE:GIS) are up 10% and 9% respectively since the end of 2007, despite giving a negative signal last January.

So even if stocks end today's session down for the month, don't fret. A down January is no guarantee of what's to come for stocks for the rest of the year -- and beyond.

For more on investing in a tough economy, read about:

• The 10 worst stocks for 2009.
• How some investors got out at the peak.
• The worst news in the last 53 years.