"Come, gentlemen, I hope we shall drink down all unkindness." - William Shakespeare
Well, there may be a lot of "unkindness" to drink down this year.
I realize this may sound preposterous, but many pundits love to take a single day of trading action to predict the stock market's direction for the full year. And the fact that stocks started the New Year by dropping almost 1% - the market's worst start since the dreaded year, 2008 - has some experts extremely nervous about what lies ahead in 2014.
Should we join them? Hmm… Are you ready for some myth busting? Because I'm about to tackle the old broker's tale that "as the market goes on the first day of the year, so it goes for the rest of the year."
Don't Fall for Recency Bias
Last year, stocks started the New Year with a pop. The Dow surged 308.41 points, its best-ever start to the year. And, well, the rest is history. Over the course of the year, the Dow hit 52 new all-time highs on its way to a 26.5% gain - its best annual performance in nearly two decades.
Fast forward to today, and we can't let the most recent events cloud our judgment. As Todd "Bubba" Horwitz of Average Joe Options wrote in a note to his subscribers, while stocks took a "pounding" yesterday, "we want to see more evidence this is a market beginning to correct." Try a lot more evidence, Bubba.
What's One Day… or Five?
Howard Silverblatt, Senior Index Analyst at S&P Dow Jones Indices - also known as the "High Priest of Stats" - reveals that the first day of the year has virtually no predictive ability. Or as he puts it;
"The opening day and full-year performance [have] moved in the same direction 50.6% of the time, with the two moving in different directions 49.4% of the time. Flip a coin."
So a pop to start last year and a thud to start this year doesn't mean that stocks are destined to head lower in 2014. What if we extend our analysis beyond one day to the first five trading days of the year? Still doesn't tell us a darn thing.
Dan Greenhaus, Chief Strategist at BTIG, says that the "First Five Days of January" indicator is similarly "baloney." Rest assured, he's not exaggerating to make headlines. An analysis by MarketWatch's Mark Hulbert last year found that there's no statistical significance between stock price moves in the first five days and over the course of the entire year.
Truth is, no matter what happens in the first five days of January, there's a 65% chance that stocks will rise that year. In other words, the long-term trend is - you guessed it, up! What if we extend our analysis to 31 days? Well, that's a different story altogether.
The Truth Behind the "January Effect"
As I shared in a myth-busting column last year, an entire month's performance does hold predictive abilities. Particularly when that month in question is January. Again, I'll turn to number-cruncher extraordinaire, Silverblatt, for the irrefutable proof. He calculated that the market adage, "as January goes, so goes the year," has been right in 62 out of the last 85 years. That works out to 72.9% of the time. While it's not a sure thing, the odds of January's performance predicting the year's overall outcome is much better than flipping a coin.
Bottom line: There are perfectly logical explanations for the stock market's poor performance on the first day of trading in 2014. Like annual rebalancing, profit taking, bad data out of China, a strengthening dollar… the list goes on. But there are no logical conclusions that can be drawn about how the rest of the year will turn out. We have to wait until the end of the first month to make those conclusions. So there's no reason to be worried… yet.