Understanding the January Effect: Why Stock Market Inflows Hit New Heights
According to Bank of America Merrill Lynch research, investors funneled an unprecedented $58 billion into equity mutual funds and ETFs during the four weeks ending January 17.
Investors have injected a staggering $58 billion into equity mutual funds and ETFs over the four weeks leading up to January 17, reveals data from Bank of America Merrill Lynch. Remarkably, $23.9 billion of this influx occurred in the final week alone, marking the seventh-largest weekly equity inflow on record, Merrill Lynch reports. While passive investment vehicles continue to attract most of the capital, this period also witnessed the largest inflow into actively managed equity funds in four years, according to their January 18 publication, "The Flow Show: Happy New FOMO."
What is FOMO?
FOMO, or "fear of missing out," as defined by Merrill Lynch, is driving investor behavior. The S&P 500 Index (SPX) reached a fresh all-time peak on Monday, closing at 2,832.97, which represents a strong 6.0% gain year-to-date. Buoyed by these robust market returns, investors are eagerly climbing aboard the equity train, as reflected in the substantial fund inflows. (For additional insights, see: Why Stock Investors Embrace the Risky 'Momentum' Strategy.)
The January Effect Explained
The "January Effect" refers to the historical pattern where stock prices tend to increase during January. Between 1928 and 2017, the S&P 500 experienced gains in January 62% of the time (56 out of 90 years), according to Yardeni Research Inc. The average gain during this month was 1.1%. When the index rose in January, the average increase was 4.1%, while in the 34 instances of declines, the average loss was 3.9%. January 2018 is poised to be the strongest opening month since January 1997, when the S&P 500 climbed 6.1%, notes MoneyChimp.com.
The 'Wings of Icarus' Phenomenon
Investor optimism is fueled by two main elements, according to Merrill Lynch: persistently low interest rates and soaring expectations for corporate earnings. Earnings forecasts are becoming increasingly bullish, with U.S. macroeconomic surveys cited by Merrill Lynch projecting a 20% growth in U.S. earnings per share (EPS), driven by an anticipated 5% to 6% expansion in real GDP.
At the same time, Merrill Lynch's Bull & Bear Indicator stands at 7.4, reflecting "frothy price action." This gauge, which measures six aspects of investor sentiment—including hedge fund positioning, credit market conditions, equity market breadth, equity and bond flows, and long-only fund positioning—signals dangerously euphoric market conditions when it hits 8.0, according to DominionFX.
Merrill Lynch refers to this segment of their report as the "Wings of Icarus," implying that the market is soaring to risky heights and could be vulnerable to a sharp downturn. (For further reading, see: The Icarus Factor.)
Triple Triggers for Market Correction
Merrill Lynch also highlights that their clients generally believe a stock market correction will only begin once all of the following conditions are met: real GDP growth forecasts surpass 3%; wage inflation exceeds 3%; the yield on the 10-Year Treasury Note rises above 3%; and the S&P 500 index surpasses 3,000.
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