Time for a New Barometer

As most experienced market participants are aware, perception is often more powerful than reality.

That seems to be the case regarding the so-called “January Barometer.” This simple indicator, which purports to discern the direction of stocks between February and December, has been bantered about ad nauseam on CNBC and has been the subject of articles in several financial publications, including Barron’s.

Simply put, the indicator portends a good year for stock investors if the market boasts a positive return in January. But if stocks tank in the first month of the year, that’s a signal the market is heading lower for the rest of the year.

According to an article in the December 25, 2000, issue of Barron’s, the January Barometer was correct in each of the previous six years, and hit pay dirt in 46 of the previous 61 years, which translates to a respectable 75% success rate. So what’s wrong with the idea?

To get a more detailed look at how valuable the January Barometer actually is, an examination of its more recent results is in order. Over the last quarter century, for example, the barometer has correctly predicted the direction of the market 19 out of 26 times, for a 73% hit rate.

Even more impressive is its flawless record over the last seven years, as the barometer has been correct in every February through December timeframe since 1995.

But when it comes to the January Barometer, things aren’t as they seem. Let’s suppose that one predicts that every rolling 11-month period from 1975 to present will be profitable. That simple guess turns out to be 86.4% accurate, which makes mincemeat out of the Barometer.

Our study shows the real Achilles’ heel of the January Barometer is its record of calling bear markets. In fact, predicted stock declines from February through December–which are supposed to follow January pullbacks–are only about 52% accurate. This result could easily be the result of random noise.

What really drives the “accuracy” of the January Barometer is the tendency of stocks to rise over time. Stocks have risen almost every year since 1975, and over most 11-month holding periods as well.

As a result, any analyst who foresees higher stock prices 12 months hence isn’t really “seeing” much.

The bottom line is this: stock gains (or losses) from February to December are totally independent of the market’s direction in January.

Source: Sovereign Wealth Management