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Nothing is ever easy. Nothing. Just last week I wrote about the “First Five Days of January” rule first revealed by Yale Hirsch, founder of The Stock Trader’s Almanac. In a nutshell, if the stock market shows a gain during the first five days of January, then the stock market subsequently showed a gain between January 31^st and December 31^st of that year 82% of the time. On the other hand, if the first five days of January was down, then the market advanced only 44% of the time between the end of January and the end of December.

In my new book Seasonal Stock Market Trends (yes, another week, another shameless plug), I presented all kinds of facts and figures regarding this amazing phenomenon. But as I said, nothing is ever easy. All of the work that I did involved using the Dow Jones Industrial Average. This year, after posting a good early gain, the Dow closed lower on the fifth trading day of 2009 than it did on the last trading day of 2008. Therefore, this should be an unfavorable signal, right? Well, maybe… because, interestingly enough, the S&P 500 showed a gain during the first five trading days of 2009. So I went to the source and asked Yale Hirsch what he thought and he said that he always had used the S&P 500 because it was more “representative of the overall market.” Great. So now what do I do? 

Well, fortunately, I am not quite crazy enough to base my entire investment strategy on this one five-day window, so whether one categorizes the first five days of January as “up” or “down” is not the be all end all of stock market prognostication. For the record, based on the methods that I wrote about in my book I am putting this down as a “no,” although it pains me somewhat. Fortunately there are other “January” based tools that I use before making a determination as to whether the market “should” or “should not” be up between January 31^st and December 31^st.

The Fabled January Barometer

The January Barometer - another Yale Hirsch original - follows the same premise as the “First Five Days” indicator. In other words, if the stock market is up in January, look for a gain between January 31st and December 31st of that year. The relevant questions to be answered then are “how reliable is this trend?” and “is this something that can actually be used to invest money with?”  To answer these questions, we will run the following test:

For the purposes of measuring performance, we will skip the month of January entirely. Then starting February 1st we will either:

A) Be long the Dow (if the month of January shows a net gain).
B) Be out of the stock market completely (if the month of January shows a net loss).

So a person using the “January Barometer” strategy would either:

A) Sit out the month of January, then be in the market for 11 months, or;
B) Sit out the entire year, depending on whether or not the month of January showed a net gain.

Chart 1 depicts the growth of $1,000 since 1937 using this strategy. As you can see, in the long run the market has tended to trend higher following a “January Barometer” bullish signal.

 

Chart 1 – Growth of $1,000: Long Dow Feb 1st through December 31st if Month of January shows a net gain (since 1937)

• A “bullish signal” occurs when the month of January as a whole shows a net gain.
• A “bullish period” extends from the close on January 31st following a bullish signal through December 31st of that year.
• A “bearish signal” occurs when the month of January as a whole shows a net loss.
• A “bearish period” extends from the close on January 31st following a bearish signal through December 31st of that year.

Having defined these terms, let’s look at some relevant results:

• $1,000 invested only during “bullish periods” grew to $89,570 by 12/31/2008.
• $1,000 invested only during “bearish periods” declined to $441 by 12/31/2008.
• The average daily gain between February 1st and December 31st following a bullish signal was +0.000443%.
• The average daily gain between February 1st and December 31st following a bearish signal was -0.000085%.
• The annualized rate-of-return during bullish periods since 1937 is +11.8%.
• The annualized rate-of-return during bearish periods since 1937 is (-2.1%).
• Following a bullish signal, bullish periods showed a gain 43 times.
• Following a bullish signal, bullish periods showed a loss 4 times.
• Bullish signals produced a gain 91.4% of the time.
• Following a bearish signal, bearish periods showed a gain 9 times.
• Following a bullish signal, bullish periods showed a loss 15 times.
• Bearish signals have been followed by market declines 62% of the time.

As you can see, the January Barometer sports a fairly impressive stand-alone track record. 91% of bullish signals were followed by a market advance and 62% of bearish signals were followed a market decline. In all, this method correctly called the direction of the stock market in 58 of 71 February through December periods. This works out to a very respectable 81% accuracy rate. Now let’s see what it looks like if we turn this into a stand-alone trading system.

The January Barometer as a Stand-Alone System

For this test we will change the rules just a little bit and assume that we will be in the stock market during the entire month of January while we wait for the January Barometer to tell us what to do for the remainder of the year. As you can see in Chart 2, the Dow has shown a net gain – albeit a choppy one - during the month of January since 1937.

 

Chart 2 – Growth of $1,000 invested in the Dow only during the month of January since 1937

Here are the rules for the system we will test for trading using the January Barometer:

A) We will be long the Dow during the month of January every year.

B) If January shows a net gain we will continue to hold the Dow through the end of the year.

C) If January shows a net loss we will exit the market and hold cash through the end of the year.

D) For this test we will assume that while we are out of the market we will earn interest at a rate of 1% per year.

Now let’s get some idea as to whether or not there is any advantage to using this strategy. In order to do this we will compare the results that we generate using this strategy to the results we might have generated using a simple buy-and-hold approach. Chart 3 displays the growth of $1,000 using this simple systematic approach versus a buy-and-hold approach since 1937.

 

Chart 3 – Growth of $1,000 invested in Dow using January Barometer versus a buy-and-hold approach (since 1937)

All told, $1,000 invested in the Dow using a buy-and-hold approach grew to $72,622 by 12/31/08. At the same, the same $1,000 invested in the Dow using the aforementioned January Barometer strategy grew to $217,519 by 12/31/08. The results generated by only being in the stock market when the January Barometer signaled a bullish outlook, roughly tripled the return generated using a buy-and-hold approach over the past 70 years.

Summary

So the question that most people dance around is this: if the Dow Jones Industrials Average shows a gain during the month of January should one throw caution to the wind and simply assume that the stock market is destined to move higher by the end of the year? Well, not necessarily. Every year is involves a new and different set of circumstances and it would be borderline irresponsible for an investor to base his or her entire investment stance based on the market’s performance over a one-month period.

Still, 91% accuracy is 91% accuracy. If the Dow can somehow manage to muster itself to end the month of January with a gain, investors should take note and perhaps be a little more willing to give the bullish case the benefit of the doubt.

To search for previous articles written by Jay Kaeppel, please click here.

Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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