Trader’s Narrative

Groundhog Day is only a few days away! According to lore, if the groundhog sees its shadow, we’re going to have another 6 months of winter. If on the other hand, it fails to see its shadow, winter will end soon.

The January barometer can be likened to ground hog day but it has more historical evidence. The January barometer basically says that the performance in the first month of the year, predicts the market’s return for the rest of the year.

The S&P 500 Index (SPX) started January at 902.99 and ended the month at 825.88 for a return of -8.5%. The Dow fared worse with an 8.8% drop. For both indices it the worst January return on record.

So the groundhog has definitely seen its shadow and the bear market will continue.

The only faint silver lining is that the historical basis for a negative prediction is very flimsy. Probably due to the upward bias of the stock market over the very long term, the prediction quality of the January barometer is higher in bull markets. So this prediction of a continued bear market has only about a 40% chance of being accurate.

UPDATE:
Here’s an interesting related article by Nick Godt at MarketWatch

The beginning of the year is a special time that rightly attracts much attention. The January effect is mostly over by now and hopefully you were able to trade this phenomena profitably. It is too bad it only comes around once a year.

There are a few other similar patterns for January. Probably the best known is “as January goes, so goes the year”. Another says that the first 5 trading days determine the market’s returns for the whole year ahead. And another says that how January performs predicts the direction of the market for the remaining months of the year.

Mark Hulbert showed a few days ago in this column that the 5 first trading day pattern simply isn’t true. In fact, the only one that does have validity historically is the third one listed above. The January Barometer says that the performance for the first month has a predictive quality for the returns generated between the second and twelfth months.

Because of the positive bias of the market, this indicator works best when it predicts a bullish scenario for the remaining 11 months of the year. From 1940 to 2008, January’s return was positive 43 separate times. Of these, 86% of the time the next 11 months were also positive. On the other hand, in only 40% of the cases when January was negative was the rest of the year also negative. The overall accuracy of the January Barometer within that time range was 73.9%.

So with an almost 75% historical accuracy rate, we’ll have to wait until the end of this month to see what it augurs for the rest of the year.

Below is a look at the raw data from 1940 to 2008:
Continue reading ‘The January Baromoter’

There a few ways to take advantage of the January effect this year:

Small & Micro-Cap ETFs
The simplest would be to buy small cap stocks or ETFs before the year end and hold until they have a pop. Since the definition of “small-cap” has been continuously revised up over the past few years, it might be a good idea to look at “micro-cap” stocks. Here are a few ETFs:

• iShares Russell Microcap Index (IWC)
• First Trust Dow Jones Select MicroCap ETF (FDM)
• Powershares Zacks Micro Cap Portfolio ETF (PZI)
• Powershares Dynamic OTC Portfolio ETF (PWO)
• iShares S&P SmallCap 600 Index Fund (IJR)
• iShares Russell 2000 Index Fund (IWM)
• iShares Morningstar Small Core Index Fund (JKJ)
• SPDR DJ Wilshire Small Cap ETF (DSC)
• Vanguard Small-Cap ETF (VB)
• PowerShares Dynamic Small Cap Portfolio (PJM)
• PowerShares Zacks Small Cap Portfolio (PZJ)

Closed End Funds
Last week I mentioned a method to capture January effect alpha which uses CEF and specifically, municipal/bond CEFs. This year is a bumper crop for this specific strategy because of the vast number of these funds which have severe losses.

Value Line Futures Index
Yet another way to play the January effect is to use the Value Line Arithmetic Index futures. This is a little known equity index compiled by Value Line Inc. - the investment research outfit. It is comprised of approximately 1,650 stocks which are equally-weighted, as opposed to capitalization weighted as in the S&P 500 Index.

The futures for this index are traded at the Kansas City Board of Trade with each contract valued at $25 times the value of the index (appx. 1324). The Value Line January effect strategy is pretty straight forward:

Buy the Value Line contract (nearby month of course) and (sell short) equal value ratio of the S&P 500 Index. Close the position in the first week of January. Depending on the calendar, around the 9th of the month. That’s it.

This simple spread trade has a remarkably high profitability ratio but sadly it only comes once a year. And the advantage it has to the other two year end strategies is that it is market neutral. Although I suppose you could short SPY to offset a long position in small/micro-cap ETFs.

Forget everything you know about the market. If you have a long enough time horizon, all you need is a calendar.

More specifically:

1. Look at the calendar
2. From May to October, stay out of the market (or go short).
3. From November to April, buy or go long.

That’s it.

Forget technical analysis. Forget fundamental analysis; watching talking heads on TV; reading blogs (cough). Or anything else.

The only catch is that you have to have time on your side. Because each and every single instance is not going to go in your favor. But on average, you’ll be far ahead of a simple buy and hold strategy.

For some strange reason, winter months are great for stock market returns and summer months are bad. This holds true across time as we go back decade after decade, it also holds true if we go across the globe and look at different stock markets in different countries.

This is known by a few names: Sell in May and go away, Halloween indicator, winter months good, summer months bad, etc. Theoretically this pattern should not exist. But it does. And it bothers a lot of economists. Most of them would rather not think about it so they just shoo away this and similar holes in the EMH.

Fact is that the Halloween indicator, like election year pattern, the January effect, 4 year cycle and many others, present not one but two challenges to EMH. One, they should not exist if the market is as economists theorize, “efficient”. Two, if they did exist, they shouldn’t persist, which they do. That is to say, if they do exist, which they shouldn’t in the first place, they certainly shouldn’t continue to exists year after year, decade after decade because theoretically, people would wise up and by taking advantage of it, remove it from occurring.

Neither of these is true, of course.

Probably the definitive report on this anomaly was published Ben Jacobsen and Sven Bouman. You can read their working paper from July 2001 in the free trading resource section (Reports & Articles).

They not only look at the pattern of stock market returns, they turn over every stone looking for an explanation. They can’t find any. But they do have some interesting things to say nonetheless:

Based on the old market saying Sell in May and go away (or the Halloween indicator), we find that there is a substantial difference between returns in the period May-October and the remainder of the year. In fact our evidence shows that while during the period November - April returns are large in most countries, average returns in the period May-October are not significantly different from zero and are often even negative.

We found that in many countries the Sell in May effect cannot be a January effect only.

Is it possible to time the market using a system that is so simple, it only requires you to be able to count up to four? Can we invest for the long term using a system that only requires a few minutes of our attention every four years?

Not only is it possible, such a system has beaten the pants off the pros in the long term. Being so amazingly successful, it has garnered a name: the four year stock market cycle.

Many theories have been put forth to try and explain it. Some say it is due to the presidential cycle, some that it is due to the business cycle, some to astrology or other esoteric phenomena. While the reasons are up for grabs the results are quite clear. And they are the sort that makes EMH proponents pull their hair out in frustration. How can something so simple, so replicable, and so consistent exist decade after decade?

While academics debate it, you can use it to boost your long-term investment account. All you need to do is to watch for a low every four years. The start year is important, so I’ll give it to you: 2006. From that year, you can go back and forward in four year increments. Those years will be (in the future) or were (in the past) great times to invest in the stock market. Or to add to an existing investment portfolio.

Take the previous cycle: 2006. That was the last intermediate low. Before that, in 2002 we had the trough of the multi-year bear that resulted from the popping of the internet mania. The one before that? 1998 which was the trough from the Asian currency contagion that shook financial markets. Keep going and you’ll see that the four year cycle marks great buying opportunities in an uncanny way.

Of course, it doesn’t have a perfect track record. But it is a damn good one. Out of the last 27 four year cycles, only 5 of them have not been great buying opportunities. They were 1946 (flat), 1930 (ouch!), 1910, 1906 and 1902. You can keep going back in time but my chart (below) stops there:

Click to enlarge graph

For extra mojo, we can combine the 4 year cycle with the annual cycle. That is, we can take the best month within the year (historically October) that coincides with the four year cycle. But remember, the four year cycle is only a guide. No individual occurence has to follow the script to the letter. All we are interested in is putting the odds in our favour as we have detected them from historical observation.

The following graph shows the decennial performance of the Dow Jones Industrial Average. Think of it as putting the annual performance of every decade into a blender and mashing them together. We get a graph that shows the average performance of each year within a decade:

As you can see, year 4 has an unusual lift that the other years don’t. If you’re sharp, you’ll notice that years 7 and 8 also have some pretty good kick as well. This data is not showing the same thing as the four year cycle but it does present us with further proof that returns from the stock market are not random. If they were, then each year would show fairly similar performance.