Tuesday, January 8, 2008

The Fallacy of the Bearish First Five Days

I will be the first to admit that one of my favorite trading books to browse through is the Stock Trader’s Almanac, complied by Jeffrey Hirsch and Yale Hirsch. The current version of this annual classic, Stock Trader’s Almanac 2008, has already been sitting on my desk for three months.

I mention this book because the authors have been instrumental in widely disseminating the idea of the ‘January Baromenter,’ which posits that “as goes January, so goes the market.” While the idea of the January Barometer dates back to at least 1972, the corollary, which should be on the mind of many investors today, is that the first five days of January provide an effective ‘early warning system’ about the trend for the balance of the year.

Before I critique these two ideas, let me point out that the data for the general premise of January as a microcosm of a full trading year is compelling. Using the S&P 500 index, the January Barometer includes only five major errors in the past 58 years; and 31 of the last 36 times the first five days were up, the year ended up as well.

But before you load up on more QID in anticipation of the market being sucked into a black hole, it is important to recognize that the data obscures what happens when the year gets off to a particularly ugly start, as it has in the first four trading days of year (through yesterday), where the SPX has been down 3.6%.

As it turns out, since 1950 the SPX has only had a five day start that was worse than 2008 on two occasions: 1978 and 1991. In both cases, however, the year managed to turn around and finish in the green. In 1978, the SPX shook off a -4.7% first five days and was up 6.0% the rest of the year. The turnaround in 1991 was even more dramatic, as anyone who owned NASDAQ stocks (up 56.8% that year) will surely recall. After falling 4.6% the first five days of 1991, the SPX was up 32.5% for the remainder of the year.

If one wants to expand the analysis to the worst full month starts since 1950, the four worst of these starts also turned around by the end of the year as well. In 1970, January was down 7.6%, but the balance of the year was up 8.4%. In 1960, it was -7.1% followed by +4.5%; in 1990 it was -6.9% and +0.3%; and in 1978 it was -6.2%, with a +7.7% turnaround from February through December.

As always, be careful with what you take away from this analysis. Of the 21 Januarys that the SPX has been down, the balance of the year was down 10 times and up 11 times. The bottom line? If there is any message worth remembering from the data above, it is that good starts tend to persist, ugly ones tend to reverse, and slightly down beginnings run the greatest risk of turning into a rout.


Bill Luby said...

David Merkel, who authors The Aleph Blog, summarizes his thinking on some of this quite nicely in his recent Momentum, Schmomentum:

* In the short run, momentum persists.

* In the intermediate-term, momentum reverts.

* Sharp moves tend to mean revert, slow moves tend to persist.

The comments on this post are worth reading also.

Do yourself a favor and put David's blog on your daily reading list, if it isn't there already.

Roger Nusbaum said...

FWIW, In Jan 1991 there was uncertainty about Iraq War I. Then the day the US attacked Iraq it was off to the races. Starting the summer before when the invaded Kuwait the market was really lousy, I know this because I was working at Lehman Bros trying to cold call my way to riches when all this was happening, lol.

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