Do you want to know how stocks might perform this year? A widely followed market theory, the January barometer, claims that as January goes, so goes the year. But evidence reveals that’s not always the case; The market gained roughly 11% in 2014, after dropping 4% in January. So, does this year’s 3.7% January loss point to a down year for stocks?
“Interestingly enough, while an up January is generally bullish for stocks, a down January is not a reliable predictor of a weak year overall,” says Jeffrey Todd, technical analyst with Fidelity. “In eleven out of twenty-five weak January years, the stock market actually ended higher, often by a very substantial amount.” Indeed, this has happened five times in the last decade alone.
A bullish start is the stronger predictor
Why might up Januaries be better predictors than down ones? One reason may be the historical proclivity of stocks to rise: Stocks have finished higher in all but 14 out of 65 years since 1950. So, the fact that stocks finish higher for the year so often after both a positive and negative January may simply be the result of this directional bias.
“There is a very strong correlation between positive January S&P 500® Index performance and positive market performance for the entire year,” notes Todd. “In fact, the January barometer has held true 37 of the 39 times since 1950 when January experienced market gains.”
Only during two years have stocks dropped sharply after a positive January (1966 and 2001), with both instances occurring at the end of powerful multiyear market advances.
Momentum is one possible reason that positive stock performance during January may actually be a reliable predictor for full-year performance. If the market gets off to a good start, a bullish trading pattern can form, and that can help fuel continued positive performance, at least through the early months, as investors jump on the trend. From a historical perspective, there is no clear evidence as to why a negative start does not more strongly imply a negative year, compared with the high correlation of a positive January translating to a positive year.
First five days
Some proponents of the January barometer believe in the “first five days” theory, which predicts that the first five days of January will point the way for the rest of the year. Over the first five days of 2014, the S&P 500 lost about a half of one percent. Obviously, that was not predictive as the market rebounded, gaining 11% for the year.
The problem with this theory is that there is significantly less historical evidence, compared with the January barometer, to support that the first five days of January are a reliable predictor of the rest of the year. Additionally, given the small number of trading days, there is not enough time for momentum to become a significant factor.
While it is impossible to predict the future, proponents of the January barometer think this indicator may provide some indication of how stocks will perform. However, the evidence is not entirely conclusive.
The January barometer provides an easily identified outcome, but crafting a strategy solely on this theory is not prudent, particularly after a down January. Investors should consider dedicating more attention to the factors that affect the business cycle and create trading patterns.
Nevertheless, if you do believe that the January barometer can help forecast how the market will perform, the 3.7% loss during the first month of the year portends a bearish 2015. But remember, the historical evidence suggests the January Barometer is not always reliable.
Past performance is no guarantee of future results.