Let 2016 Be The Year The January Barometer Died

| About: SPDR Dow (DIA)
This article is now exclusive for PRO subscribers.

Summary

The January barometer failed once again as 2016 delivered an up year despite a down January.

The January barometer might be more useful as a BUYING indicator.

I present the historical data behind the failures of the January barometer, and analyze its potential alternative uses.

Two years ago, I wrote "The Problem with the January Barometer." An old Wall Street adage effectively encapsulates the January barometer with the saying "as January goes, so goes the year." I wrote after January, 2014 delivered an apparently ominous 3.6% decline for the S&P 500 (NYSEARCA:SPY). The index went on to gain a whopping 11.4% for 2014. The January barometer failed yet again. The year of 2015 returned the January barometer to good graces as January lost 3.1% and the year ended with a 0.7% loss. The year of 2016 marked the third year in a row for a down January with a 5.1% loss for the month. Yet, the January barometer failed one more time with 2016 delivering a stellar 9.5% gain. Hopefully, 2016 helps put the January barometer to rest. In fact, perhaps the January barometer could better be stated as "buy the dip at the end of a down January."

So let's review the updated numbers.

First, it is important to remember that, in general, the S&P 500 delivers annual gains. For example, since 1982, the beginning of the last big bull market, the index has ended the year with a loss only 9 of 37 years (24%). Since 1951, the index has lost only 18 of 66 years (27%). Thus, having a barometer that predicts an up year based on the performance of any given month is nearly useless. Regardless of any given month's performance, you can simply bet on an up year.

So what do the stats say about predicting a down year based on the performance of a given month? Since there are only 18 negative years since 1951, I can use a heat map to compare the performance of each month of a negatively performing year to see whether there is even a chance of getting a reliable prediction. It turns out that 78% of negative years have a negative January. However, June and September are even worse. In other words, IF you believe the S&P 500 will deliver one of those rare negative years, prepare to short most aggressively in the months of September, June, and January, in that order. After September, just relax. (Statisticians will note the statement of conditional probability here).

When the S&P 500 has one of those rare off years, we should expect to see a lot of negative months. Some months tend to fare worse than others.

Source for prices: Yahoo Finance

Now what if you are not a permabear or you do not have a premonition about the S&P 500 trading down for the year? Can the performance of January, or any month for that matter, help predict a negative year? Since 1951, negative performances in January or March produce the best odds. Unfortunately, 48% of the time either of those months end with a loss, the given year ends with a GAIN. This error is called a false positive. The following chart shows the rate of false positives by month (red bar, left vertical axis) alongside the total number of months with negative performances (black dots, right vertical axis).

There is no month that provides a reliable predictor of a negative year because the rate of false positives is too high.

Finally, just to underline the weakness of the January barometer, I generated a bubble chart of the January barometer married to the performance of February. Regardless of size or color, the bubbles only show a weak correlation between January's performance and the performance for the year, whether negative or positive. The calculated correlation is 0.54. (Partitioning does not help as the correlation for positive Januaries is 0.3 and a woeful -0.1 for negative Januaries). The size of the bubble shows the magnitude of the price change in February where green indicates a positive change and white indicates a negative change. I used white for better contrast, otherwise red would have of course been a better color given the color scheme I used in the chart above.

Little correlation exists between the performance of January and the year even when accounting for February's subsequent performance.

Bottom-line: the failure of the January barometer in 2016 essentially confirms its lack of usefulness. The barometer would be much more useful as a buying signal to get the year's performance at a likely discount. Going into 2017, my trading focused on confirming (calendar-independent) signals that are flashing bearish. I describe my latest assessment in "A Surprising Bearish Divergence for the S&P 500." I was expecting a fresh breakout to new all-time highs on the S&P 500 to refresh the bullish signs in the market that were in place in the days preceding the U.S. Presidential election. Instead, I found surprising signs of underlying weakness. Regardless of the way these signals resolve, I recognize that resolution into a negative January performance will NOT reliably predict a negative year.

The S&P 500 broke out of a Bollinger Band (NYSE:BB) squeeze and printed a new all-time high.

Source: FreeStockCharts.com

(For those interested, you can click here to download and review the Excel spreadsheet I used for this analysis).

Be careful out there!

Disclosure: I am/we are long SDS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.