By Angel Clark, VectorVest, Inc.
Predicting where the stock market will be a year from now would be little more than a lucky guess, but the January Barometer is used by some investors to do just that. It's also ridiculed by just as many.
The January Barometer is a theory that was initially postulated by Yale Hirsch in 1972. It's about as simple as you can get - the overall gain or loss of the S&P 500 during the month of January will set the stock market's tone for the rest of the year. If the S&P ends January higher than the first trading day of the year, 'barometer believers' would expect the market (represented by the S&P) to generally trend higher for the rest of the year as well and vice versa if January ends in a loss.
The Barometer theory sounds about as scientific as spin-the-bottle and while impressively accurate pre-1984 (70% accuracy on bullish calls and a whopping 90% accuracy on bearish calls), its accuracy on the bearish calls has declined dramatically. Since 1985 its batting average for predicting down markets has come down to a lowly 50%. Looking a little deeper, the accuracy of the January Barometer's bullish signals come into question as well - their 70% success rate appears to be completely coincidental since the S&P has also risen more than 70% of the time since 1938 (refer to quote below) - hence the scoffing from some investors that this indicator could be any more reliable than daily horoscopes and psychic hotlines.
But the folks at Stock Trader's Almanac valiantly defend the value of this indicator: "Statistically... In the 75-year history examined last Friday [1/18/2013], there were only 22 full-year declines. So yes, the S&P 500 has posted annual gains 70.7% of the time since 1938. What is missing from this argument is the fact that when January was positive, the full year was also positive 89.4% of the time and when January was down the year was down 60.7% of the time. Also, every down January on the S&P 500 since 1938, without exception, has preceded a new or extended bear market, a 10% correction, or a flat year."
But wait - the Barometer actually has two components, the full month of January gives one indication of the market's trend, but the 'early warning signal', which is based solely of the S&P's first 5 trading days of the year, also provides a glimpse into the future. According to The Stock Trader's Almanac, the stock market has gone up 85% of the time when the S&P 500 goes up in the first five trading days of January, a much more compelling (or at least intriguing) statistic. Unfortunately, the S&P's 2014 start wasn't that great, so does this spell doom for the market for the rest of the year?
Plot twist! Get ready for a 180.
The Stock Trader's Almanac freely admits that the January Five-Day Indicator has a spotty record - almost a contrary indicator in midterm election years. In the last 16 midterm years, only eight entire years followed the direction of the First-Five Days and only two of the last nine (2006 and 2010). In the case of midterm years in the presidential cycle, the full-month January Barometer proves to be the better indicator with a statistical accuracy of 66.7%.
Scary stuff if January continues in the same direction it has begun.
Further to the possibility of a substantial correction, Jeffrey Hirsch, co-editor of the Almanac writes, "midterm elections have a history of being a bottom picker's paradise. In the last 13 quadrennial cycles since 1961, 9 of the 16 bear markets bottomed in the midterm year. ... [T]his has provided excellent buying opportunities. ... From the midterm low to the pre-election year high, the Dow has gained nearly 50% on average since 1914." Hirsch anticipates "a good hunk of the next major downturn to transpire in 2014" with a low in the DJIA 12,000 range likely.
Not very encouraging news, but the month is not done and no indicator, let alone a human prognosticator, is anywhere close to 100% accurate. So where does that leave investors? Should you be worried? Avoid opening your brokerage statements until 2015? Dump your stocks now and high-tail it to the relative security of bonds?
At VectorVest, we believe it's too soon to predict the market's downfall. Due to the maturity of our current bull market investors should not become complacent but there's no need to panic or avoid the market's continued uptrend. Overly anticipating a correction that may never come (based on the opinion driven statements of others or a single month's gain or loss) could cost you a great deal in missed profits. Instead, be sensible. Risk can be controlled with a little planning and common sense.
First and foremost, let the trend be your guide - the trend of the market should be your first consideration, then the stock's trend - both should be moving up. Choose a few technical analysis indicators such as moving average crossovers, MACD, stochastic, etc... to determine if the trend is on your side. To further limit losses, consider setting stop-losses on every position to limit the overall damage to 2% or less of your total portfolio value. Other defensive management techniques include buying put options to protect your open positions or hedging with short-positions or inverse ETFs.