Move on, January: At least two more months they have a greater predictive power of stock market profitability than you.
January has a reputation for being able to forecast the direction of the US market for the next 11 months of the year. This supposed capacity is known as the “January predictor” and “January barometer”.
You will see many references to this indicator in the coming days, now that January is officially on record as the “lowest” month, with the S&P 500 SPX,
slipping 1.1%. I wrote earlier that the January Predictor rests on an unstable statistical basis. However, financial headlines will mislead the alleged negative implications of the January decline for the rest of 2021.
Let me point out a few other ways in which it is not worth following the Predictor.
What’s so special about January?
A good place to start is to remember that January 2020 was also a low month (0.2%) and yet the next 11 months produced a profit well above 18.4% (assuming that reinvest dividends).
This is just a data point. Another clue that January is nothing special is that other months have even greater predictive “powers” when it comes to predicting the direction of the stock market over the next 11 months. In fact, since the creation of the S&P 500 in 1954, in fact, June has the strongest predictive capacity, followed by February. January ranks third.
So why not read about a June predictor or a February barometer? My intention is that followers are less motivated by statistical rigor than by the stories and narratives that capture their attention. From a behavioral point of view, the calendar year is a more natural period to focus on than the February-February or June-June periods. But psychological significance is different from statistical significance.
The importance of real-time testing
There’s another telltale sign that the January indicator isn’t all it’s about: it doesn’t pass real-time testing.
I mean by this tests performed after it was initially “discovered”. If the January predictor had been able to pass these tests, we would have much more confidence that it is not just the result of a data mining exercise in which historical data is tortured long enough to emerge a pattern.
But he was not able to do it. According to an academic study on the subject, as far as I know, the real-time test of the January Predictor begins in 1973. This is the first mention on Wall Street. Unfortunately, his record since then is much less impressive. In fact, since 1973, not only is it not significant at the 95% confidence level that statisticians typically use to determine if a pattern is genuine, it is not even 85%.
It should come as no surprise to us; in fact, the January predictor is in good company. Think of a study that appeared last May in the Financial Studies Review. 452 alleged statistical patterns (or “anomalies”) that had found previous academic research to be examined were examined. The authors of this recent study were unable to reproduce these results in 82% of cases. The remaining 18% turned out to be much weaker than originally reported.
There is no correlation between the magnitude of the increase and the January return over the next 11 months
Another clue that the January predictor is based on an unstable statistical basis is that there is no correlation between market strength in January and its gain over the next 11 months. If there was this correlation, we could invent a plausible account of investor confidence at the beginning of the year that is maintained for the rest of the year.
But this correlation does not exist. Because of this absence, to believe in the effectiveness of the January predictor you would have to believe that an S&P 500 gain of only 0.01 has the same predictive power as a gain of 13.2%. This strains credulity.
By the way, I chose this 13.2% in my illustration because it’s the biggest January gain of the S&P 500 since its inception in the mid-fifties. This came in 1987. From January 31 of that year until the end of 1987, the S&P 500 lost 9.9%.
To take advantage of a statistical pattern, you have to follow it religiously for years
Finally, even if the January predictor is based on a solid statistical basis, you will have to act on it for many years in a row in order to rationally try to take advantage of it. A good general rule in statistics is that you need a sample of at least 30 before the patterns are significant. In the case of the January predictor, that means you should be following it for three decades. In addition, during these 30 years you will not make any other transaction except change to a 100% equity allotment every January 31st when the stock market increases in January and a 0% allotment if the market falls in January.
If you lack patience and discipline, do little to improve your odds above those of the currency.
The conclusion? For all intents and purposes, you cannot conclude anything about the January stock market decline on the spot where it will be located on December 31st.
Mark Hulbert regularly contributes to MarketWatch. Your Hulbert Ratings keeps track of investment bulletins that pay a fixed fee to be audited. You can contact him at [email protected]
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