Does January Predict the Rest of the Year?
The January Barometer is summed up in a single easy-to-remember phrase: "As January goes, so goes the rest of the year." This tidy maxim seems to have reasonable evidence to back up its record for prognostication, but trading it might require judgement and skill.
This indicator was first printed in the publication "The Stock Trader's Almanac" and authored by Yale Hirsch, who first mentioned it in his 1972 edition of the book. The pie chart below shows the strong reason why such a phrase would be considered valuable information. Since 1928, the S&P 500 has had 91 occasions to test the January Barometer, and in 63 of those years, the market did close in the direction that January took over the remaining 11 months of the year. By comparison, all other months, on average, were significantly less likely to be as well correlated as January.
The January Barometer Track Record
The indicator's performance over the past 91 years may look better in the past than in recent years. The chart below averages all price moves for the S&P 500 (SPX) over the past 20 years into a single seasonality graph. By this measure, observers can see that, on average, January seems to do exactly the opposite of the rest of the year. What could explain the difference?
The averaging in seasonality charts obscures the extreme moves that can occur through the year and often appear in January, especially around earnings season. Traders would likely fare better using a few rules to guide their attempt at buying stocks in January, while buy-and-hold investors should likely prepare for a bit of volatility in that month.
Solving the Problems with this Indicator
The two main problems with the January Barometer are, first, that its track record shows the indicator only forecasts correctly just under 70% of the time, and second, that it assumes investors will hold on through the index's drawdown. Over the years, this has proven to be problematic. With at least a dozen occasions of more than a 30% drop in market prices over the past century, it becomes important for investors and traders alike to be forewarned and forearmed.
The chart below shows that the January Barometer helps with this somewhat. As it turns out, the years where the Barometer does correctly forecast the market appear to exhibit a smaller average drawdown and median drawdown compared to years where January goes one way and the markets another for the rest of the year. This suggests that a stop-loss order placed just beyond the normal degree of fluctuation seen in years where the market is slightly better behaved might come in handy.
In fact, as the graph below indicates, if you place a 10% stop-loss order below your entry, this will protect your capital better in non-matching years (years where the barometer doesn't predict the market) as compared to matching years. Such a rule would have been triggered about 30 times out of the past 91 years, giving investors a chance to protect against an average of 11% additionally adverse moves.
The Bottom Line
The January Barometer is right more often than not, but it leaves a lot to be desired as a trading or investing rule. Instead, consider it an indicator of overall market health. That way, you can maintain a bullish stance and use it to improve confidence in your trading during a year when January has closed higher for the month.
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