“As goes January, so goes the year”
The “January Effect” refers to the directional move of the S&P 500 (as proxy for the entire stock market) in January dictating its directional move for the rest of the calendar year nearly 77% of the time. In other words, when the index rises in January, full-year returns tend to be positive, and when the index falls in January, full-year returns tend to be negative.
Well, we just closed January 2025 with the S&P 500 up 3%. Does this mean the 17-year long moon-shot of the stock market (since the Global Financial Crisis in 2008) will continue in 2025?
Instead of directly applying macroeconomic factors or business conditions toward answering that question, it makes more sense to first translate them to their impact on liquidity (availability of capital) with which to drive financial markets. Let's face it, global financial markets have decoupled from physical economies for decades now, — thanks to financialization which started on Wall Street and in the City of London back in the 1980s, later “infecting” financial hubs everywhere in the world via globalization. Today, stock markets in major financial centers are driven purely by global liquidity (available cross-border capital flow) and nothing else:
Currently in the U.S., liquidity driving the stock market stems from three major sources: Corporate buybacks of their own shares, the “Yen carry trade” and passive 401K contributions to “target date funds” (monopolized by Vanguard) which mindlessly chase the the most recent best-performing top 20 stocks (analogous to the “Nifty Fifty” phenomenon back in the 1960s) with zero regard for how overpriced those stocks have become (relative to their projected earnings):
None of these sources of liquidity should be driving the stock market, of course. Instead, the stock market should be driven by market participants’ judgment on the prospect of specific industries, companies, and the broad economy as a whole. But that's the normal world we have not been living in for decades now. The perverted world we do live in is what it is, — purely driven by liquidity.
So back to the question on whether 2025 will be another up year for the stock market:
- For one, a good 2024 profit picture argues for trend-continuation. This will avail capital for continued corporate stock buybacks, thus fueling yet another bull year in 2025:
- Then there are Trump’s tariffs. The 349M spendthrifts of the U.S. represent “customers of last resort” for a world in synchronized recession. The McKinley style tariffs suggested/threatened by Trump will theoretically boost tax receipts and dampen government borrowing, thus making capital more available to private borrowing (fueling asset appreciation). Further, by cajoling foreign manufacturers to produce inside the United States (to avoid tariffs), he can generate organic economic growth which will further improve the profit picture in the preceding point.
- Greenland (strategic sea lane, rare earth and other critical materials), Mars etc. are all about continued U.S. exceptionalism via future dominance in energy and tech (AI, Quantum Computing, etc). American animal spirit is very much alive in these dawning days of Trump 2.0 and should be a magnet for global capital flow (i.e. increased liquidity) into U.S. financial markets.
That all said, there are a number of arguments for a market downturn in 2025.
- First, consider the current tsunami of insider-selling of stocks (which increases liquidity in the form of sideline cash, but only in wait for a market pull back to first occur):
- If Trump is true to his stated desire to shrink the trade deficit, then the capital surplus (inflow of foreign capital from trade surplus) will also shrink. This means reduced liquidity and asset price deflation. We'll see how this plays out.
- Trump is dead serious about de-globalization and reindustrialization of America. Tariffs (against both friends and foes) are very much part of his toolbox to accomplish that end. Retaliatory tariffs won't matter much since we export so little. However, virtually all large U.S. companies will be hurt by the tariffs Trump levies due to their extensive supply chains abroad. Liquidity for stock buybacks will diminish with profitability, and thus the stock market will react negatively to tariffs.
- From 9/28/24 to 01/20/25, the US dollar has risen non-stop against the other majors (Euro, Yen). Tariffs will only further strengthen the dollar (because the recipient of tariff will lower its interest rate in response to a weakening economy thus also weakening its currency against the U.S. dollar). A stronger dollar creates a shortage in the Eurodollar market and forces foreigners to sell U.S. assets (stocks and Treasuries) to raise U.S. dollars. This is why Trump wants a lower interest rate/weaker US dollar, which will raise import costs, erode purchasing power and stealthily inflate away existing debt. As later discussed, the bond market is wise to this ploy and is driving up long bond rates (which will in turn drive up the U.S. dollar) to fight this. On the other hand, tariffs can be used as a “stick” for negotiating currency adjustments (as in the case of the Plaza Accord back in the 1980s). Whether Trump will utilize that to steer the U.S. dollar lower, along the trajectory of Trump 1.0 (see chart below), remains to be seen. If so, it will be a tailwind for liquidity. If not, it will be a headwind.
- Globally, liquidity is on the downtrend. Fund managers have very little cash (as percentage of their total Asset Under Management) on hand:
- Viewed another way, this same low cash reserve means the need to raise cash (sell financial assets) in a hurry at the first sign of financial market stress:
- Global central banks are currently capacity constrained and unable to create as much liquidity as needed to fund global public (government) debt-roll obligations.
- The US Treasury market has been signaling all through 2024 the weightiness of the U.S. public (government) debt-roll obligations. The benchmark 10-Y Treasury yield has been going up all through 2024, despite Fed cuts on the (overnight) Fed Funds Rate. This is the bond market (aka “bond vigilantes”) demanding higher term premium to ensure positive real rates (i.e. fighting Trump’s ploy to stealthily inflate away existing debt). All through 2024, Janet Yellen sidestepped this challenging situation by relying on the banking sector (via reverse repo facilities and money market funds) to fund short term Treasury Bill issuance. But that well has run dry and now in 2025, $6T of these T-bills come due and need to be refinanced. Scott Bessent will have no choice but to “term out” this debt-roll to long bonds, sucking up a lot of scarce global liquidity:
- Meanwhile, half of the Russell 2000 (small to medium sized) companies are money losing and heavily indebted. $1.5T of these loans are coming due and need refinancing in 2025, vying for the same pool of increasingly scarce liquidity. They are being crowded out by the government. Already-high bankruptcy rate will be even higher in 2025, leading to layoffs which will reduce liquidity for passive 401K contributions. Unemployment is always the last leg of progression toward recession:
The 16 times normal immigration at the southern border by Biden policy was made possible through NGO financing (with fiscal deficit spending) and designed to prop up labor statistics and delay a long overdue recession. It is now rapidly coming to an end under Trump's administration. Recession soon to follow will further reduce liquidity for corporate stock buybacks. The extent of liquidity reduction will determine the severity of financial market downturn:
- The previously mentioned rise in long bond rates will further impair bank balance sheets already saddled with material unrealized losses from their massive Treasury holdings purchased earlier at much lower interest rates (a la the failures of Silicon Valley Bank, First Republic bank etc. in Q1, 2023). There will be more bank failures in 2025 for the Fed to deal with. Credit contraction will obviously reduce liquidity (and exacerbate recessionary pressures). It may even trigger Black Swan events (can the latest Deutsche Bank situation be the canary in the coal mine?).
- Rise in long bond rates will put downward pressure on growth (read: tech) stock prices whose valuations (based on the Discounted Cash Flow model) are based on earnings far into the future. This is exacerbated by spikes in such rate rise due to speculative bond trading (sharp rise in the MOVE volatility index will be the first sign of such occurrence, and act to limit further liquidity availability).
- As previously mentioned, the Yen Carry Trade is one of three major sources of liquidity driving up U.S. financial assets. Japanese interest rates are inching up, strengthening the Yen in the process. Yen Carries become unprofitable and more expensive to pay back. These trades have to be unwound (selling of U.S. assets, most notably Treasury bonds, to repatriate Yen). This can become a major downward pressure on the U.S. bond market and eventually the U.S. equity market.
- Then there is the DeepSeek wakeup call. The Mag 7 companies have committed hundreds of billions of dollars to build a moat around American dominance in AI (don't forget Open AI went from open source to now very much closed source). Overnight, their sky high valuations are revealed to be a bubble sustained by two ingredients, — a compelling narrative (lofty projected earnings guaranteed by American exceptionalism) and plentiful credit (some of Nvidia's revenue is the result of vendor financing and much of other committed investments are based on financiers willing to lend the money). The first is called into question resulting in the second inevitably being scaled back in 2025. NVIDIA already lost $600 billion of market cap in one day from lowered future earnings expectation. The rest of the Mag 7 will suffer the same fate soon when their projected earnings growth fail to materialize (to pay for outrageous CapEx already spent).
- A little-thought-of source of liquidity is Short Interest. Shorts (borrowed and) sold before they bought. Their eventual buying (to close out their positions) represents liquidity that will drive the market up. Currently, the market is all-long and no-short:
So which will win out, — the January Effect or all these negative liquidity considerations? Let me throw in two more factors for consideration. First, there is the Presidential election-cycle effect, — in the immediate post-election year, stocks always go up in January, go down in February, and end with an up year (thus supporting the January Effect):
But wait, there's also the superstition factor: Going back to the 1800's, the US stock market has tended to decline in the Year of the Snake:
So what are we to believe?
Well, seasoned market participants are all acutely aware of Bob Farrell's 1st rule of mean reversion. Current valuation and performance concentration in the stock market is at generational high which historically invites imminent reversion to the mean:
There can be no argument the currently overstretched market — 17 years in the making — is a bubble “long in the tooth”. Bubbles are not by happenstance. Bubbles are intentionally blown by the financial elite to make more money. Bubbles are meant to be burst (how else can the financial elite “buy low” again, after “selling high”?). Do they intend to further stretch this mega bubble for another year (in the face of increased unemployment and bank/enterprise failures, synchronized global recession, and perhaps even global currency reset)? If I were Trump, and serious about recapitalizing the US financial markets and restructuring the US economy, I would rather have the cleansing happen sooner than later. Market crash and recession will create the crisis and excuse (remember “never let a crisis go to waste”?) for the inevitable hyper-print, — which will result in lower rates, lower dollar, higher neutral reserve asset (gold? Bitcoin?) value for global currency reset.
The snake may just make an exception of the January Effect this year.
