Every January, 401(k) investors do something that influences the stock market for the remainder of the year.
Few are aware of this correlation between 401(k) investor behavior and the stock market, however. That increases the chances that the pattern has not been discounted away by investors acting on it and thereby killing the goose that lays the golden egg.
Better yet, this correlation is surprisingly easy to follow and act upon.
Credit for documenting this correlation goes to a 2018 study called the “January Sentiment Effect,” which appeared in the International Review of Financial Analysis. Entitled “The January Sentiment Effect in the U.S. Stock Market,” its authors are Zhongdong Chen of the University of Northern Iowa and Phillip Daves of the University of Tennessee Knoxville.
What 401(k) investors often do in January is make changes to their retirement portfolios’ asset allocations. Crucially, those changes affect not only the division of their current holdings between stocks and bonds, but also the allocations of each of their subsequent monthly contributions to their 401(k)s—both the amounts they withhold from their paychecks, but also the amounts that their employers contribute as a match. So the decisions investors make in January have ripple effects for subsequent months as well.
Unfortunately, marketwide data on 401(k) investors’ asset allocation decisions aren’t available. So the professors had to look for some proxy in order to document the correlation between those decisions and the stock market. They settled on the University of Michigan Index of Consumer Sentiment (ICS), theorizing that when that index rises in January 401(k) investors are more likely to increase their equity allocation—with bullish implications for the remainder of the calendar year. Just the reverse would be true if the ICS fell in January.
Sure enough, the professors found just such a correlation in the historical data. They analyzed all years since 1978, when the ICS was created. In the years since then, in which the ICS rose in January, the stock market produced above-average performance from February through December—and vice versa.
To be sure, 401(k) investors can make asset allocation decisions at any time of the year, not just at the beginning of the year. But, as a matter of practice, most 401(k) investors appear to make such decisions just once a year, in January.
Consider what the professors found when they looked at ICS changes in each of the other 11 months of the calendar. Unlike for January changes, they found no correlation between any of those other months’ sentiment changes and the stock market’s subsequent returns.
What the January Sentiment Effect says about 2021
You may recall that I first wrote about this “January Sentiment Effect” a year ago, when it was positive. The S&P 500
from the end of January 2020 through the end of the year gained more than 16%. This year, unfortunately, the “January Sentiment Effect” is negative: The ICS at the end of January stood at 79.0, down 1.7 units from its end-of-December reading.
Needless to say, 401(k) investors’ asset allocations decisions aren’t the only factors influencing the stock market’s direction. So the ICS’ January decline doesn’t amount to a “run for the hills” sell signal. Still, insofar as the future is like the past, that decline means there will be an extra amount of downward pressure on the stock market for the rest of 2021.