History is laden with strategies that worked for a time, then became ineffective, and were subsequently abandoned.
Examples can be found in product development, marketing, and even comedy. But the easiest place to understand this phenomenon might be in military battlefield tactics. From the ancient times when bow, arrow, and horse were battleground standards, no real significant technological advances came to the military until gunpowder was first employed in the 14th century.
For thousands of years, military tactics rather than technology were of paramount importance on the battlefield. One of the most famous, effective, and enduring formations was the Greek phalanx. In this formation, soldiers packed densely together with interlocking shields and used long spears. The strength of the phalanx lies in its unified and seemingly impenetrable front.
Tacticians made many variations to the original rectangular formation and the phalanx reached its peak effectiveness under the command of Alexander of Macedon, better known as Alexander the Great. His use of unbalanced phalanx formations, along with his ability to move troops quickly, combined with brilliant field leadership to bring this military strategy to its zenith.
And then, following the death of Alexander, the phalanx died very soon afterward as well. The faster and more flexible three-line Roman Legion proved very effective against the phalanx formation. The Roman conquest of the Greek city-states and the rest of the known world followed.
Like the rise and fall of the phalanx as a useful military strategy, the famous January Barometer has come to the end of its useful life. Just as the agile Roman Legion overwhelmed the phalanx, quick and volatile markets have killed the January Barometer as well.
Many Discuss It, Few Understand It
In the coming days, we head into the end of January when pundits will write and talking heads will talk about the January Barometer in glowing terms. Don’t be sucked in by their hype.
The indicator was first presented by Yale Hirsch in 1972 and lives on in the Stock Trader’s Almanac authored by Hirsch and his son. I keep an up-to-date copy of the almanac on my desk and find it has many useful references. But this particular indicator has gone the way of the phalanx – once useful but now only of historic interest. Let’s dig into the numbers to see why.
On the surface, the January Barometer has an impressive track record with an 84.5% accuracy claim over the past 71 years. Those are the numbers you’ll hear quoted over and over again. It is calculated quite simply: If January presents a positive return for the S&P 500, the January Barometer predicts that the full calendar year will be positive and vice versa for a down January.
The indicator makes an exception for any year where the market moves less than 5% in either direction. Those neutral or flat years are then not counted for or against the track record – a reasonable exception. Given that caveat, the January Barometer has only been wrong eight times in the last 65 years – a credible job of predicting up and down years. That is, until we look at its recent performance.
If we break down the January Barometer signals into decades and see how many times it is correct out each decade, we start to see a problem. Let’s look at how many misses (an up January as part of a down year or vice versa) and how many flat years there have been per decade. Once we subtract misses and flat years from 10, the remaining years in the decade are the ones that the indicator can claim to be helpful:
As you can see, the usefulness or efficacy of the indicator dropped off drastically in the last two decades. In fact, the indicator has been useful only in 8 years out of the last 20. This is not a statistically significant sample but the shift raises the question as to whether a once interesting indicator has any effectiveness in predicting market direction.
Perhaps there has been a change in the investment behaviors that drive markets – the tax selling of stocks in December that turned into January buying may no longer be a significant factor. Regardless of whether underlying investing practices have changed, the structural nature of the markets has changed. The markets have become more volatile and large-scale direction changes occur more quickly and go further since 2000. But let’s dig one level deeper into the logic flaw that just breaks the usefulness of the January Barometer.
Flawed Logic Dooms the January Barometer
The Stock Trader’s Almanac judges the performance of the January Barometer by using calendar year results, when those gains (or losses) already contain the January returns. It’s a bit like saying that a football team that outscores its opponent in the first quarter is likely to win the game (or vice versa).
If you used the strategy to trade, you would have to buy on the first trading day of February and exit on the last day of December, sitting out the month of January each year. That strategy, over the last 20 years, results in a net loss (even though 2008 returned a whopping 40.1% return!).
The January Barometer may have had a good run “back in the day”, but in today’s faster news cycle driven market, it’s not even useful for cocktail talk …
I’d love to hear your thoughts and feedback – just send an email to drbarton “at” vantharp.com.
Great Trading,
D. R.