How much does history drive your decision making? While past performance is certainly no guarantee of future performance, it seems as though historical returns serve as a core tenet of many investing philosophies. When stocks don’t live up to expectations, this idea is then hedged by saying that over the “long-term,” returns will work out as expected. If you are a believer in using history as a guide for your investment decision making, or even if you are a trader looking to piggy-back on those who use history as a guide for investing, the following data might interest you:
Perhaps you’ve heard of the “January Barometer” or “The First-Five-Days-In-January Indicator” popularized by the Stock Trader’s Almanac. The “January Barometer,” formulated by Yale Hirsch in 1972, states that the returns of the S&P 500 (SPY) for the year will follow those of January. In other words, if the S&P 500 is up in January, it will end up for the year. Likewise, if the S&P 500 closes down in January, it will end down for the year, according to the “January Barometer”. There have been only 15 errors since 1950, giving the “January Barometer” a 75.4% success rate. As an aside, it should be noted that the S&P 500 didn’t exist in its current form until later in the 1950s.
“The First-Five-Days-In-January Indicator” has an even better success rate than the “January Barometer.” It states that during the last 39 years in which the first five days of trading saw the S&P 500 rise, the S&P 500 ended the year with positive returns in 33 of those years. This amounts to an 84.6% success rate for “The First-Five-Days-In-January Indicator.” Indeed, these would be the two January indicators many investors have heard about.
The following piece of history, however, is less known: Never in the history of the S&P 500 has it closed up by 1.80% or more after five trading days and not finished the year with a positive return. Let me state this a bit differently: 100% of the time that the S&P 500 finished its first five trading days with a return of 1.80% or more, it has finished that calendar year with positive returns. Through January 9, 2012, the S&P 500 is up 1.837%.
Since the S&P 500 debuted on March 4, 1957, it has finished its first five trading days with a return of 1.80% or more 14 times. Of those 14 years, 11 of the years recorded double-digit gains for the index ranging from a low of 12.3% in 1979 to a high of 38.1% in 1958. The three times the index did not record a double-digit gain after gaining more than 1.80% in its first five trading days were in 1987 (2.03%), 1984 (1.40%), and 2004 (8.99%). Furthermore, only once since 1957 did the S&P 500 not record further gains at year-end beyond the first five days of trading when it ended those first five days up at least 1.80%. This means that investors who bought at the close on that fifth day of trading made money in every year except 1984, during which they would have lost only 1% of their principal. However, when factoring in dividends, the investors would have made money in 1984 as well.
Naturally, history does not have to repeat itself. Given all the uncertainty investors must currently contend with, perhaps it is unwise to consider following this indicator in 2012. However, if you are interested in sticking with this indicator, which has a perfect record over the history of the S&P 500, here is something to keep in mind: take a look at the stocks in the S&P 500, the Dow Jones Industrial Average (DIA), and the Nasdaq 100 (QQQ) with the biggest weightings. There is some overlap between the three indices, and given the widespread use of indexing as an investment model, the top-weighted stocks in those indices will be the most important in deciding the returns the overall market has in 2012.
As an example, if Apple’s (AAPL) stock, with its more than 15% weighting in the Nasdaq 100, were to ever experience a sharp selloff, it could cause a sell-off in most of the Nasdaq 100 due to the widespread use of indexing in investment portfolios. This would mean that Nasdaq stocks like Microsoft (MSFT), Intel (INTC), Cisco (CSCO), Oracle (ORCL), and QUALCOMM (QCOM) could suffer simply because Apple’s stock is selling off. Why is this important? Those five stocks have S&P 500 weightings of 1.79%, 1.11%, 0.88%, 0.90%, and 0.81% respectively (as of 1/5/2012).
When combining this with Apple’s 3.35% weighting in the S&P 500, those six stocks alone have an 8.84% weighting in the index. Think about what the total weighting would be if we added up the weightings of all Nasdaq 100 stocks that also belong to the S&P 500 and the impact those stocks could have on the S&P 500.
This is why it is important to know what the most influential stocks are in each of the major indices if you want to try to figure out whether history can repeat itself with respect to the historically perfect indicator discussed in this article. Think about things that you believe could potentially cause the largest-weighted stocks in an index to fall in 2012. Perhaps they will miss earnings forecasts at some point this year. Perhaps they will keep growing strongly, but the multiple will simply contract. Perhaps macroeconomic events take all stocks down regardless of fundamentals. If none of these things concern you, then perhaps you have just found your buy signal in this never-before-failed indicator.