Opinion: What the market decline in January means for stock returns in 2021

You’ll see plenty of references to this indicator in the coming days, now that January is officially entered in the record books as a “down” month – along with the S&P 500 SPX,
-1.93%
sliding 1.1%. I have already written that the January Predictor rests on a shaky statistical base. Financial headlines will nonetheless proclaim the supposedly negative implications of January’s drop for the remainder of 2021.

So let me point out a few other ways the Predictor isn’t worth tracking.

What is special about January?

A good place to start is to remember that January 2020 was also a month of decline (down 0.2%) and the following 11 months produced a gain well above average of 18.4% (assuming that dividends have been reinvested).

It’s just a data point. Another clue that there is nothing particularly special about January is that the other months have even greater predictive “powers” in forecasting the direction of the stock market over the next 11 months. Since the inception of the S&P 500 in 1954, in fact, June has the greatest forecasting capacity, followed by February. January is in third place.

Why, then, don’t you read a June predictor or a February barometer? I have the impression that members are motivated less by statistical rigor than by the stories and narratives that capture their attention. From a behavioral standpoint, the calendar year is a more natural time to focus on than the February to February or June to June periods. But psychological significance is different from statistical significance.

The importance of real-time testing

There is another telltale sign that the January indicator is not all it is supposed to be – it does not pass real-time tests.

By that I mean tests carried out after its initial “discovery”. If the January Predictor had passed these tests, we would be much more convinced that this is not simply the result of a data mining exercise in which historical data is tortured long enough to cause a pattern to emerge.

But that was not possible. As far as I know, the real-time test of the January Predictor begins in 1973. This is the first mention of it on Wall Street, according to an academic study on the subject. Unfortunately, his record since then is much less impressive. Since 1973, in fact, not only is it not significant at the 95% confidence level that statisticians often use to determine whether a trend is genuine, it is not significant even at the 85% level.

We shouldn’t be surprised; in fact, the January Predictor is in good company. Take a study published last May in Review of Financial Studies. He examined 452 supposed statistical models (or “anomalies”) that previous academic research had uncovered. The authors of this recent study could not reproduce these results in 82% of cases. The remaining 18% were found to be much lower than those initially reported.

No correlation between magnitude of rise and return to January in next 11 months

Another clue that the January Predictor has a shaky statistical base is that there is no correlation between the strength of the market in January and its gain over the following 11 months. If there was such a correlation, we might be able to whip up a plausible story about investor confidence at the start of the year, postponed for the rest of the year.

But there is no such correlation. Because of this absence, to believe in the effectiveness of the January Predictor, one would have to believe that a gain in the S&P 500 of just 0.01 carries as much predictive power as a gain of 13.2%. It undermines credulity.

By the way, I chose this 13.2% in my illustration because it is the biggest January gain for the S&P 500 since its inception in the mid-1950s. It came in 1987. From January 31 of this year at the end of 1987, the S&P 500 lost 9.9%.

To benefit from a statistical pattern, you must follow it religiously for years

Finally, even if the January Predictor had a solid statistical foundation, it would have to be acted upon for many years in a row in order to rationally try to profit from it. A good rule of thumb in statistics is that you need a sample of at least 30 before patterns become meaningful. In the case of the January Predictor, that means you’ll have to follow it for three decades. Also, in those 30 years, you would not undertake any other transactions other than switching to a 100% equity allocation every January 31 when the stock market rises in January, and an allocation at 0% if the market in January is down.

Without this patience and discipline, you do little to improve your odds above those of a toss.

The bottom line? For all intents and purposes, you can’t conclude anything from the stock market’s decline in January about its situation as of December 31.

Mark Hulbert is a regular contributor to MarketWatch. Its Hulbert notes follow investment newsletters that pay a fixed fee to be audited. It can be reached at [email protected]

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