Daily Options Report

I thought of a better analogy to the misleading January Effect. You know those baseball stats they throw out about how great Team X is at holding leads? Like the Astros are 70-3 when then lead after 8 innings something like that. Sounds impressive, but then you hear the whole league holds about 95% of their 9th inning leads.

My point on January is not that it doesn't happen, rather that they're mistaking it for something unique.

Anyway, Mark Hulbert answers all the questions we had. Hat tip Abnormal.

Consider first the notion that the first five trading days of January are able to foretell the stock market's direction for the rest of the year. I tested this notion by applying it to the Dow Jones Industrial Average back to 1896, when this benchmark was created.

It turns out that, if the first five days of January were up, the stock market proceeded to rise 68% of the time from then until the end of the year. If the first days of January were down, in contrast, the market for the rest of the year was up 56% of the time.

To put these percentages in context, consider that the stock market on average has risen in 64% of all years since 1896. So the market's likelihood of rising was 4 percentage points higher when the first five trading days of the year were positive, and 8 percentage points lower when those first days were negative.

Even if those differences in probability were statistically significant, I am not sure that they are big enough to make it worth investors' while to act accordingly. But they are not statistically significant--at least at the 95% confidence level that statisticians often use to determine if a pattern is genuine.

Another telling statistic: The first five days of April and May have better forecasting records than does January, even though neither of those additional months' forecasting records is significant at the 95% confidence level either. Yet I've never heard any of the talking heads refer to a "first five days of April" or a "first five days of May" indicator.

Precisely! And there's more.

What about the other indicator based on the stock market's behavior during January -- the notion that the stock market's direction from February through December is foretold by its direction in January? At first blush this so-called January Indicator appears to have a better record than the "first five days of January" indicator, though there still are reasons not to make too much of it.

Since 1896, the Dow has risen 72% of the time from February through December when January was up. In contrast, when January was down, it has risen just 50% of the time over the subsequent 11 months.

Relative to the 64% frequency that the market has risen in all years, therefore, a positive January increases the odds of an up year by 8 percentage points. And a down month in January decreases those odds by 14 percentage points. Notice that these are bigger shifts in probability than the ones that emerged from testing the "first five days of January" indicator. In fact, furthermore, they are marginally statistically significant.

Bear in mind, however, that other months besides January also possess this apparent ability to forecast the market's direction over the subsequent 11 months; November stands out in this regard. So January is not entirely unique. Why don't Wall Street's talking heads also talk about a November Indicator?

The ultimate irony is we're in a stretch where the indicator did not work well at all. But is it me, or is it getting more buzz this year than in recent past?

Basically, the market remains in a low volatility uptrend until proven otherwise. This will pass when it passes, but there's rarely some sort of magical reset right after New Year's.