Do the first five days predict the full year?

The January Effect refers to the tendency of small cap stocks to out-perform large-cap stocks in the month of January. However, the term January Effect is used rather loosely to also refer to stocks generally being strong in the first month of the year, and also to how the direction of the market in January forecasts the market direction of the whole year (this latter effect is also termed the January Barometer). [A previous article explained the multiple January Effects in greater detail.]

Here, we are going to look at a variant of the January Barometer to see if the first five days of the year predict the return for the whole year.

First, we will call this variant of the January Barometer: January Barometer (5D).

The bald figures don’t look encouraging: in the 46 years since 1970, the January Barometer (5D) applied to the FTSE All-Share Index has been right in 26 years (57%). In other words in just over half the years since 1970 the first five days of the year have accurately forecast the full year.

But let’s look at this in more detail and see if we can tease anything out of the figures

The following is a scatter chart that plots the return on the FTSE All-Share Index for the first five days of a year against the return for the full year, for the period 1970-2015.

FTSE All-Share Index first 5-days v full year return [1970-2015]

There is a positive correlation here (given by the positive sloping trend line), however the measure of correlation (R2) is very low.

Summary: the chart shows there is a very low level of correlation between first five-day returns and returns for the full year but it is far from being significant.

However, strictly, the January Barometer only says the direction (i.e. positive or negative returns) can be forecast, not the size of returns. In which case the following chart may be more useful. This plots a binary value for each year:

  • 1: if the sign on the full year return was the same as the sign for the return for the first five-days (i.e. either both positive returns or negative returns)
  • -1: if the sign on the full year return was different to the sign for the return for the first five-days

FTSE All-Share Index first 5-days predicts full year [1970-2015]

In this chart we can see the roughly even split between years when the January Barometer (5D) works and those years when it doesn’t. However, the distribution of years when it works is interesting, as there does appear to be a certain clustering of years when the effect works and when it doesn’t.

For example, in the last 20 years the January Barometer (5D) has been accurate 14 times (a hit rate of 70%). And since 2004 there is this rather odd pattern of not working every fourth year.

US presidential elections

US presidential elections also have a four-year cycle. On the chart presidential years are marked with orange bars.

It can be seen that since 2004 the January Barometer (5D) has worked every year except in years before presidential elections.

And, over the longer term, since 1970 the January Barometer (5D) has only failed in three presidential elections (a success rate of 73%).

The outlook for 2016

Generally, the January Barometer (5D) has a low success rate. However, the effect has been more significant in recent years; plus it has a higher significance in US presidential election years (which 2016 is). In 2016 the market was down in the first five days of the year, and so the January Barometer (5D) would forecast a down year with a 73% probability.

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The January Effect(s)

It’s January, so let’s talk about the January Effect.

But which January Effect would that be?

We’ve come across three different uses of the term. A quick overview follows.

1. Small-caps out-perform large caps in January

The most common use of the term January Effect describes the tendency of small-cap stocks to out-perform large-cap stocks in January.

In 1976 an academic paper found that equally weighted indices of all the stocks on the NYSE had significantly higher returns in January than in the other 11 months during 1904-1974. This indicated that small capitalisation stocks out-performed larger stocks in January. Over the following years many further papers were written confirming this finding. In 2006 a paper tested this effect on data from 1802 and found the effect was consistent up to the present time.

The UK market experiences the same January Effect as seen in the US market. The small cap out-performance in January is significantly strong: the FTSE Small Cap Index has out-performed the FTSE 100 Index by an average 3.7 percentage points in all Januaries since year 2000. And the small cap index has under-performed the FTSE 100 Index in just one year in the past 13.

The following chart shows the average FTSE Small Cap Index out-performace of the FTSE 100 Index for each month since 2000.

2. January predicts the market for rest of the year

Historically, the returns in January have signaled the returns for the rest of the year. If January market returns are positive, then returns for the whole year have tended to be positive (and vice versa).

This is sometimes called the other January effect, or January Predictor or January Barometer and was first mentioned by Yale Hirsch of the Stock Traders Almanac in 1972. A variant of this effect has it that returns for the whole year can be predicted by the direction of the market in just the first five days of the year.

Academic research has largely found that January returns can predict the rest of the year, but there is some doubt as to whether the effect can be exploited.

And Dan Greenhaus of BTIG points out that January is not necessarily any better a predictor of full year performance than any other month. According to him,

When February is down, the 12 month return inclusive of that February is 2.0%. When February is up, the S&P 500 returns 12.53%

and similar for the other months.

3. The market tends to rise in January

In 1942 Sidney B. Wachtel wrote a paper, “Certain Observations on Seasonal Movements in Stock Prices”, in which he proposed that stocks rose in January as investors began buying again after the year-end tax-induced sell-off.

Looking at the returns for the FTSE 100 Index since 1984, it is true that they tend to be positive – but not strongly so. The index has risen in 57% of all Januaries since 1984 with an average increase of 0.3% – which ranks it in eighth place of the 12 months.


References

Other papers:

 

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