Adam O’Dell | Friday, January 31, 2014 >>
Mark Twain was neither a stock market analyst nor a statistician, yet he contributed two famous quotes that could make you think otherwise.
“History never repeats itself, but it does rhyme.”
True. That’s why market analysts dig deep into historical price data, looking for patterns that sometimes provide clues about the fortunes of the future.
While each year’s market is individually unique, like a fingerprint, investors who’ve been around longer than Facebook know that some years’ market performance “rhymes” with prior years. As such, we aim to let history serve as our guide.
By the same token, statistical studies inform us on probabilities… never certainties. Or as Mark Twain put it in his second comment, there are…
“Lies, damned lies, and statistics.”
Also true. We should never rely solely on historical statistics and future probabilities without a keen eye for the present day’s reality… and a healthy dose of common sense.
So with these ideas in mind, let’s look at this year’s January Barometer…
The idea behind this indicator is that the stock market’s annual return is predictable based on the market’s performance in January.
The dumbed-down inference is this: “If January is up, the year will be up. If January is down, the year will be down.”
Which brings me back to Mark Twain. While I do value the January Barometer, that dumbed-down inference is a damned lie!
And here’s the chart to prove it.
That’s quite a lot to digest, so let me explain…
I’ve taken data on the Dow Jones Industrial Average (DJIA) going all the way back to 1924. For each year, I’ve plotted the January return on the x-axis and the annual return on the y-axis.
My goal was to determine the relationship between January’s gain and that year’s gain.
There are two important things I learned from this chart.
The first is that the trend line representing 89 years of data is sloping upward. This implies that, in general, positive returns in January are predictive of positive returns for the year.
This observation is why the January Barometer has been dumbed-down to the positive-January-equals-a-positive-year (and vice versa) version.
The second, more important point is that annual returns don’t turn negative until a January return is worse than a 6% drop. We know this because the trend line only crosses under the y-axis (implying a negative annual return), when the x-axis (showing January returns) falls below -6%.
In fact, there have been a number of years in which January started in the red, losing as much as 6% that month, only to go on to finish the year higher. The light-green rectangular box in the chart highlights those occurrences.
What does this all mean for markets this year?
Well, the Dow is down 4.2% in January 2014. Plugging that number into the trend line equation above spits out a prediction for the annual gain we might expect this year… which comes to +1.5%.
However, you should take that number with a grain of salt.
This study showed a standard deviation of annual returns equal to roughly 20%. That means that instead of a 1.5% annual gain, it’s well within the realm of probabilities that we’ll see a gain of 21.5%… or a loss of 18.5%.
So instead of fixating on the forecast, let’s rather address what I suspect is your biggest fear: that the market will decimate 50% or more of your investment portfolio between now and December.
Harry’s demographic and cycle research has identified this year as particularly vulnerable to a meaningful decline in the stock market.
That said, he and I both agree that it won’t be a one-directional trade to the bottom. Even if stocks continue to decline through the first quarter, we’ll still likely see a re-test of highs. Bull markets don’t just give up suddenly or easily.
Even if 2014 proves to be the start of the downturn, as Harry forecasts, it could last into 2020 before Harry’s cycles turn higher again. During that time, there could be many highs and many lows.
As it turns out, the stock market’s performance over the prior three years is a better predictor of annual returns than January’s performance.
That is, a healthy, positive return over the prior three years is predictive of stronger annual gains this year (when gains are had). It’s also predictive of milder annual losses this year (when losses are suffered)… even when January’s performance is negative.
And that’s exactly where we are this year. The Dow has returned 43% over the past three years. And the Dow has fallen 4.2% this January.
Plugging those numbers into the statistic models I pulled together suggests a range of returns in 2014 between -8.9% and +21%.
The most important point to walk away with today is this: Be prepared for volatility. And know that, regardless of what this year holds in store for us as investors, there is always a way to make big gains… so stay flexible.
Playing both sides will be even more important in 2014!
And that’s something we can help you with. Sign up for Boom & Bust to gain access to my portfolio of recommendations (on both the long and short sides).
And keep reading Survive & Prosper.
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