Debunking the January Barometer

Standard & Poor's 500-stock index plummeted 8.6% in January, leading many prognosticators to conclude that stocks will likely continue to drop the remainder of the year. Don't count on it. After falling in January, stocks historically have tended to rise in the subsequent 11 months.

Like every myth, the so-called January barometer contains a grain of truth -- but only a grain. The stock market's performance last year provided ammunition for this barometer's fans: The S&P 500 plunged 6% in January, and the index lost 38% for the entire year.

The January barometer started as a belief that if stocks rise in January, they will rise during the subsequent 11 months of the year. At first glance, this indicator seems to have some validity. When the market rises in January, two-thirds of the time it goes up the rest of the year.

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But Mark Hulbert, editor of the Hulbert Financial Digest, put the kibosh on this nonsense. The fact is that the stock market goes up about two-thirds of the time -- regardless of what happens in January. So the barometer is practically worthless.

Next, devotees turned the barometer on its head: If the market falls in January, it tends to fall for the rest of the year, the theory's advocates argue.

Once again, reality says otherwise. Hulbert, whose publication tracks the performance of investing newsletters, looked at returns of the Dow Jones industrial average from 1897 through 2008. He found that when the Dow fell in January, its average monthly return for the subsequent 11 months was 0.25%.

Still, a negative January does contain a smidgen of predictive value. In an average month, the stock market rises 0.57%-more than twice as much as it does over the 11 months following a losing January.

Indeed, Hulbert found that when the market rises in January, on average it gains 0.69% per month from February through December. That's a soupçon more than the 0.57% the market returns in an average month. But here's the catch: The return for most months exhibits a slight tendency to predict which way the market will head next.

It turns out that market performance in December has been slightly more accurate at predicting the subsequent 11 months than its performance in January (the S&P 500 rose about 1% last December). November is the third most accurate month (the S&P plunged 7% in November).

Why does one month's return predict what will happen over the ensuing 11 months? Momentum works, to some degree, in the market. When the market is falling, odds are it will continue falling. When it's rising, odds are it will continue rising.

But the predictive ability of these months, including January, has been tiny -- far too small to profit from once you pay commissions, even the piddling charges of a discount broker.

And three months have no predictive ability at all: February, August and September.

The bottom line is clear: The January barometer is a fantasy. Ignore it. Had you followed it in 1982, you would have stayed out of the market for the remainder of the year. But the market gained 25% during the last 11 months of 1982-a year that marked the beginning of the greatest bull market in history.

Want to make money from January? There is a "January effect": The tendency of stocks of small companies to do better than stocks of large companies in the first month of the year.

It has been proven to work. Reason: Investors tend to dump their losers near the end of the year to claim tax losses, and, because small-company stocks are more volatile than their larger brethren, they tend to fall harder. In January, after tax-loss selling abates, small-company stocks rebound more strongly than the large-capitalization stocks do.

Trouble is, the phenomenon has become so widely known that professional investors have taken advantage of it to the point that it no longer works reliably, or it starts to work well before January. This year, small-cap stocks lagged large-company stocks in January. The large-company-dominated S&P 500 lost 7%, while the small-company Russell 2000 index lost 10%.

Moreover, to truly benefit from the January effect, you have to engage in esoteric strategies involving the purchase of a basket of small-cap stocks and the sale of a basket of large-cap stocks. After all, the January effect says nothing about whether stocks will go up or down, only that the little guys will beat the big guys.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.