January market slump likely to continue

Stocks took a pause in January, especially in the riskiest markets, with the S&P 500 Index slipping 3.7%. My two model portfolios, of exchange-traded funds and 401(k) mutual funds, did much better but still surrendered some of last year’s profits.

Traditionally, a weak January presages a negative year for domestic equities, although last year was an exception. I don’t attempt to time the market so signals like this don’t interest me much. I do think, however, that weakness will continue until we get a little more clarity on conditions in Washington. As Thomas Friedman noted in today’s New York Times, the United States under Barack Obama suffers the kind of political instability usually associated with countries like Venezuela.

So I’m making no changes to the models, except to tidy up excess cash in the ETF portfolio. I expect a full-fledged correction–i.e., a decline of more than 10%–in global equities, and if it comes I’ll take profits in bonds and add to my stock holdings. Fundamentally the future is much stronger than the recent past, not least because Congressional Democrats are being emasculated.

Bonds did very well in January, and both of my models benefited from large fixed-income positions. Let’s look first at the model 401(k) portfolio.

Bonds zagged when stocks zigged

Foreign securities, especially those in emerging markets, took the biggest hit in January. Developed markets overseas, for bonds as well as stocks, were hurt by weaker currencies. The U.S. Dollar Index, a trade-weighted measure, rose 1.4% during the month, continuing a rally that began in November. Since its nadir, the index has advanced 5.3%.

Developing markets were the victims of risk aversion, which also showed itself domestically, with small capitalization stocks doing much worse than their big-cap brethren. You’ll recall that I saw that coming, and cut back my emerging-markets stake late last year.

Let’s turn now to the ETF model portfolio.

Securities' selection aided returns

This model, like that for 401(k) investors, performed better than the market primarily because the individual securities it owns are better than run-of-the-mill index funds. Note that despite the 3.7% decline in big-cap domestic stocks held by the S&P 500, my big-cap funds did better. That’s because they’re tilted toward beaten-down value stocks, which tend to outperform when the economy is perking up. It definitely is; GDP jumped 5.7% in last year’s fourth quarter.

Contrariwise, both models were held back in January because of their heavy weighting in foreign securities, including bonds. That overweighting is a strategic decision, based on what I think is likely long-term weakness in the U.S. dollar. Today’s deficits, including the trade deficit, are a millstone around the dollar’s neck. So the current strength of the dollar is an anomaly, I think, that will not last.

Meanwhile domestic bonds are doing great. So I tidied up the excess cash in the ETF model, produced by a flood of dividends received in December, by purchasing an additional 17 shares of Vanguard Short Term Bond.

Obama has run into almost exactly the same wall that Bill Clinton hit early in his first term. Clinton, ever the pragmatist, immediately pivoted toward the center, and had the most successful administration any Democrat has enjoyed since FDR.

Obama, however, seems to be an ideologue, in the unfortunate mold of Jimmy Carter. Even worse, he reacted to losing Massachusetts by spouting populist nonsense, which has ominous overtones for everything economic from taxes to tariffs to environmental regulation. There are just as many populist yahoos in Congress on the right as the left. They could unite to overcome gridlock, and gridlock is the economy’s only friend in Washington.

So investors are cautious, as well they should be. Politicians since Augustus have turned to the circus to take the mob’s mind off their failings, and no good has ever come of it.