The January Effect/Indicator/Barometer

Happy 2018! Through yesterday, the stock market has greeted the new year with a 1.8% rally in the large company S&P 500 Index, a 2.53% spike in the technology laden NASDAQ, and a 1.32% rise in the small company Russell 2000. If you haven’t already, you will likely start to notice pundits making predictions based upon what these gains mean for the upcoming year.

Among the list of January predictors you will see frequently noted are the January Effect, January Indicator, or January Barometer. Some versions attribute January market action to seemingly plausible theories of traders buying back stocks that were sold in December for harvesting tax losses, or that in certain years of a Presidential term there is a higher likelihood of stimulus from the government. Others, simply that as the market goes in January, so it will go for the whole year. What they all have in common is some version of a theory that you can reliably outsmart the market by recognizing and taking advantage of patterns in January.

I tend to think of it like saying that the score in the first half of the first football game of the season somehow predicts a team’s final record. You know, like how Texas A&M had a 39 – 10 lead over UCLA at halftime in their 2017 season opener, only to eventually lose the game and finish the season 7-5 and firing their coach? But I digress.

What may be helpful to remember is that January is named for the Roman god, Janus.[i] He was the two faced protector of gates and doorways, looking back into the past with one face, the other into the future. Janus reminds us that trying to predict the future by looking back obviously predates the advent of current markets or gridiron pastimes. But the question remains, did past Januaries provide reliable indications of what the rest of those years had in store?

Bearish Starts Are Unreliable Predictors

Let’s say the market reverses and ends the month in the red, should investors then sell stocks? Exhibit 1 shows the monthly returns of the S&P 500 Index for each January since 1926, compared to the subsequent 11-month return (i.e., the return from February through December). A negative return in January was followed by a positive 11-month return about 60% of the time, with an average return during those 11 months of around 7%.

This data suggests there may be an opportunity cost for abandoning equity markets after a disappointing January. Take 2016, for example: The return of the S&P 500 during the first two weeks of this year was the worst on record for that period, at -7.93%. Even with positive returns toward the end of the month, the S&P 500 returned -4.96% in January 2016, the ninth-worst January return observed from 1926 to 2017. But a subsequent rebound of 18% from February to December resulted in a total calendar year return of almost 13%. An investor reacting to January’s performance by selling out of stocks would have missed out on the gains experienced by investors who stuck with equities for the whole year. This is a good example of the potential negative outcomes that can result from following investment recommendations based on an “indicator.”

Exhibit 1.      

January Return vs. Subsequent 11-Month Return of the S&P 500 Index 1926–2017

Bullish Beginnings Have Been Better Barometers

Januaries that are up, on the other hand, seem to have been better predictors than down ones. But keep in mind that stocks tend to rise more than they fall, having finishing higher in all but 23 years since 1926. There is some academic evidence, however, that momentum in the markets is an observable phenomenon [ii] where winners continue to outperform and losers underperform. While I certainly embrace evidence based approaches to investing, I believe the most effective way to capitalize on momentum is through patient trading strategies within my models and by incorporating funds that apply similar principles to their trading.

Conclusion

Over the long term, the financial markets have rewarded investors. It is human nature to look forward while trying to somehow use the past as a predictor for what is to come, but there is little evidence that it works. Recent articles offering similar observations can be found in reports from Bloomberg, CNBC, Fortune, MarketWatch and USA Today .

People expect a positive return on the capital they supply, and historically, the equity and bond markets have provided meaningful growth of wealth. As investors prepare for 2018 and what the year may bring, we should remember that frequent changes to an investment strategy can hurt performance. Rather than trying to beat the market based on hunches, headlines, or indicators, investors who remain disciplined can let markets work for them over time.

If the current rally has you wondering if you should change your investment approach, get in touch for a free psychometric risk profile.

[i] https://www.almanac.com/content/origin-month-names
[ii] http://business.nasdaq.com/media/Fact_Fiction_and_Momentum_Investing_Israel_Frazzini_Moskowitz_and_Asness_tcm5044-42326.pdf

Portions adapted from the January 2018 Issue Brief from Dimensional Fund Advisors LP. .

Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.

There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. Investors should talk to their financial advisor prior to making any investment decision. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their financial advisor prior to making any investment decision.