The January Barometer: A Case Study in Trying to Predict the Unpredictable

Apr 18, 2019

Past performance does not indicate future success.  (Yeah, we know.)  Just because you see a pattern, doesn’t mean there is one.  But all the disclaimers in the world still won’t keep investors (and some advisors) from basing judgements on what they can see.  Matt Potter from SEI’s Investment Services team steps in this week with an interesting post, making a great case for diversification and why following a disciplined process still makes sense for all investors.

We’re all familiar with the phrase, “Past performance does not guarantee future results.” It can be found on the vast majority of materials that our industry produces (including this one). But ask yourself, how many people invest as though they actually believe this disclaimer? How many investors can honestly tell you, for example, that they’re not swayed by a mutual fund’s recent performance? Or that they’re unconvinced that a top quartile or top decile fund is probably more likely than not to perform well in the future?

Human beings are pattern-seeking, and we like predictability. As a result, if we observe enough data points to produce something resembling a coherent pattern, we often make the assumption that there is a consistent cause-and-effect relationship at work, driving the results that we see. Furthermore, if our causal hypothesis makes intuitive sense to us, we may be tempted to assume that we can make reasonable predictions about the future by relying on these patterns, sometimes to our detriment. Often, as the cliché goes, it works – until it doesn’t.

Let me offer an example. In February of 2018, SEI produced a short piece discussing the so-called “January Barometer.” We noted that since 1950, in years when the stock market rose more than 4% for the month of January, performance during the remainder of the year had nearly always been quite favorable. At that point, there had only been one year in that multi-decade data series – 1987 – when a January gain of more than 4% was followed by a negative return for the rest of the year.

Exhibit 1: When January Gains More than 4% in the S&P 500 since 1950

Data are computed from the S&P 500 Index since 1957 and S&P 90 Index from 1950 to 1957.
Performance quoted is past performance. Past performance does not guarantee future results.

Since we had just experienced a 5.6% gain (in price-only terms*) in January 2018, it would have seemed like a pretty safe bet that February through December 2018 would usher in some fairly solid stock market returns, and things did indeed look quite good – up until late September.

Unfortunately, past isn’t always prologue, and we all know now that the 4th quarter of 2018 was quite unpleasant for U.S. equity investors. The updated chart below highlights how 2018 thus became the second calendar year since 1950 in which January strength was followed by a weak 11-month return. 2018 marked a rare exception to what looked like a very reliable rule.

Exhibit 2: UPDATED: S&P 500 Index January Gains of More than 4% since 1950

Performance quoted is past performance. Past performance does not guarantee future results.

To be fair, we did put this indicator into context at the time we first highlighted it: “We recognize that the January Barometer and other technical indicators based on historical price patterns are slim reeds upon which to base a forecast of future prices. Economic fundamentals and valuations must come into play at some point, too.”

And indeed, there were a number of additional reasons for optimism at that point, including a synchronized global economic expansion, strong corporate earnings, recently enacted tax-reform legislation, and global central bank monetary policy that remained accommodative. Nevertheless, in 2018, this indicator didn’t work. The pattern that we had seen hold true in 18 out of 19 similar prior observations did not play out as expected in 2018.

So what’s the lesson here? Simply that the future is incredibly difficult, if not impossible, to predict in any consistent or reliable way.

Even when we think we have established a strong cause-and-effect relationship, there’s always the possibility that we may have convinced ourselves to see a pattern or relationship that simply isn’t there. Or, if there is an underlying pattern or trend, we may overestimate how frequently it holds and assign it a higher level of predictive value than is warranted.

And the beat goes on

Interestingly, January of 2019 presented us with another month in which the S&P 500 rose more than 4%. Should we conclude that the January effect has ceased to be a reliable indicator, given how we may have felt burned by its ineffectiveness only last year? Or was 2018 just an anomaly, with 2019 now presenting an opportunity for this predictive indicator to reassert itself? These questions are somewhat akin to asking whether you should favor momentum (trends from the recent past are likely to persist) or mean reversion (the pendulum always swings back).

In practice, each of these approaches is effective at times – the hard part is trying to assess ahead of time when one will work and the other won’t, and when that situation will reverse itself.

Investment implications

So what are the investment implications of all this? Perhaps it is having an appreciation for what is and isn’t knowable, or expecting the unexpected. Attempts by anyone to predict the future likely come from a desire to control it, a goal that simply isn’t attainable. Even the most reliable economic or market indicator – whether it’s the January effect or yield curve inversions – can fail at times.

Now, none of this should be construed as an argument for being fatalistic or cause us to throw up our hands helplessly. Rather, it means we should intelligently position portfolios in an attempt to maximize the odds for long-term success, while also accepting that there will likely be periods during which this positioning may appear to be misguided.

As an advisor, you can conclude that a diversified portfolio is one of the keys to successful investing. We can council investors to carefully consider all investment options and work together to select investments based on their individual needs and goals. In other words, investors can be best served by a process that combines risk-appropriate asset allocation, sensible diversification, a longer-term perspective, along with a realistic dose of humility about our forecasting abilities.

*The S&P 500, generally quoted, is a price-return index that does not account for dividends; it only captures the changes in the prices of the index components.

The S&P 500 Index is an unmanaged, market-weighted index that consists of the 500 largest publicly traded U.S. companies and is considered representative of the broad U.S. stock market.

Investing involves risk including possible loss of principal. Diversification may not protect against market risk.

Index returns are for illustrative purposes only and do not represent actual fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice and is intended for educational purposes only.

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John Anderson

John Anderson

John Anderson is the creator and lead author of Practically Speaking blog and Managing Director of Practice Management Solutions for the SEI Advisor Network.

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