Lessons from the Pros

What is the Accuracy of the January Barometer?

The goal of this article is to scrutinize the assumption that if the stock market is up in the month of January, it will be up for the rest of the year, or vice versa. In order to do a proper study, one of the major ETFs was selected, namely the IWM which tracks the stocks of the Russell 2000. The data that was looked at included the last nine calendar years.

Sometimes the news media refers to this phenomenon as the January Effect. Before we move on, let’s accurately define the January Effect. I chose to pull up the definition of the January Effect from Investopedia.com. At that website, two definitions are given, the first one being a dictionary explanation: "A general increase in stock prices during the month of January generally attributed to an increase in buying." It states, "…the drop in prices typically happens in December when investors, seeking to create tax losses to offset capital gains, prompt a sell-off."

One must say that this insight, if accurate, is a most intriguing one. To recap the essence of it: There is a sell-off in December. If this is accurate that there is, every December, a sell-off just before the years’ end, then where is the famous Santa Clause rally? Please, review last week’s article. Now let us proceed to the actual definition of the January Effect which is NOT the general dictionary definition but Investopedia’s definition. Investopedia explains it more narrowly by specifying the fact that the January Effect impacts small caps (read the components of the Russell 2000) more than mid or large caps. It is for this reason that I have selected for my scrutiny the IWM, the exchange traded fund that tracks the Russell 2000.

The definition then commences even a deeper explanation of historic trends and the possibility of the markets adjusting for the January Effect. At the end, Investopedia states that "… the January effect is now considered less important…" I wish to emphasize the word NOW. Whatever the January Effect meant in the past, in 2009 and now 2010, might not be as important. The reason for it, according to Investopedia, is "…that more people are using tax-sheltered retirement plans and have no reasons to sell at the end of the year for a tax loss."

I do suggest keeping this last point in mind when the next year starts and the talking heads on CNBC might be making reference to the January Effect, when in fact they mean the January Barometer.
What the January Barometer actually means is quite simple: As January goes, so goes the rest of the year. As I have pointed out by using Investopedia.com, the January Effect means that small-cap stocks tend to outperform the large-caps. Or in simple words, IWM does better than SPY which tracks the Standard & Poors 500. Make sure that when listening to the talking heads, you have a healthy skepticism towards the opinions that you hear thrown around on the TV. They might not always know the correct definition or they might not have the right context for the specific term that they are using. Therefore, I suggest that you always look to the charts to verify the information yourself.

Now, let us proceed with our study. Below you will find charts displaying data covering the last 8 calendar years. The charts have monthly candles on them. Each January candle has a rectangle around it. Notice that there are two different colors used for the rectangle fill; those January monthly candles that have yellow rectangles around them have lines pointing out to what happened to the price action of IWM for that calendar year. For simplicity’s sake, I have also typed up the words "Wrong" and the year for each of those that did not work out.

Figure 1

Let us read the chart from left to right. The first rectangle in yellow is for the month of January 2001. It is in yellow because the candle is green (bullish), yet by the end of December of 2001, IWM was slightly down. The yellow rectangles mean that the assumption – up in January equals up for the year – was off. In 2002, the first candle is in blue and it means that the prediction worked out just fine; the candle was in red and we closed in red for 2002. Thus far 1:1, and no conclusion can be made.

The January 2003 candle was a bearish one, but at the end of 2003, IWM was up; so wrong one more time. However, 2004 brought in the first candle in green and by the end of 2004, IWM was up. One more time 2:2, and again no clear conclusiveness. Notice then that in 2005, the January candle was red but IWM closed slightly higher for the year, while in 2006 as January went, so did the rest of 2006. The candle for January 2006 was green and IWM closed higher for 2006; again 3:3. In 2007, January was slightly up, but by the year’s end, IWM closed lower. Now we are coming to more recent history that the majority of people remember: January of 2008 was a big red candle and IWM did close with big losses for the year. The bigger picture score was still 4:4. This year the January candle was telling us the wrong thing. We are closing higher than the month of January, bringing the score to 5:4 out of nine tested years.

In conclusion, there is no such thing as an absolute in the market. The observation that in every even year (2002, 2004, 2006, and 2008) the January candle prediction worked, and in every odd year it did not, would be oversimplification. The market could at any time break any rule so do not fall for the false statements that certain things always happen. There are no absolutes in the market, trust the charts and back-testing rather than the TV. Have a Happy and prosperous New 2010 Year.

- Josip Causic