The Trader’s U E-Letter: Issue # 169

Thursday, January 05, 2006

Stock Indicators: Don’t Bet the Farm On January’s First Five Days Indicator

By D.R. Barton, Jr. Chairman, Trader’s U

Oft expectation fails, and most oft where most it promises.

— William Shakespeare

Today, Trader’s U continues a fine tradition — uncovering stock indicators that just don’t work. And the market indicator getting the most press this week is the First Five Days of January. Rest assured, it just doesn’t work.

You see, at the core of human nature is the desire to understand complex systems in simple terms. Problem is, we tend to apply this simplistic cause-and-effect model to very intricate problems — and expect similar easy-to-understand answers.

The Washington Redskins Indicator

In presidential election years, for example, consider the Washington Redskins Indicator Since 1936, a Redskins win in their last home game had been followed by a win for the presidential incumbent, and a loss meant a loss for the incumbent. (The streak was finally broken in 2004, when the Redskins lost at home to Green Bay — despite my attendance — and the Republicans retained the White House.)

Or perhaps, the Groundhog Day Indicator Weather systems are as complex and difficult to predict. But we have devised many ways to predict the weather, including the infamous groundhog, Punxsutawney Phil. If he sees his shadow on February 2, there will be six more weeks of winter weather.

Because we like simple explanations, we are more than willing to believe cause-and-effect explanations that really don’t make logical sense.

Maybe that’s why there are so many stock forecasting tools that use shaky logic and even shakier statistics to predict what will happen in the market in the days and months to come.

One of the Most Hyped Stock Market Indicators: January’s First Five Days (It’s Popular, But It Ain’t Useful)

Many market watchers and analysts are looking at the well-known First Five Days indicator, which has been popularized by Yale Hirsch’s Stock Trader’s Almanac. (For more on the Almanac, see Tips and Tricks below.)

For the record, I think the Almanac contains a wealth of useful information. I keep one on my desk and gave two as Christmas gifts to friends and family. But back to our dubious market indicator

The First Five Days in January indicator holds loosely that the direction of the first five trading days of the year is a valid predictor of the direction of the market for the remainder of the year.

As proof of the indicator’s effectiveness, it’s proponents look at a 55-year record and state that of 35 First Five Days that finished up, the stock market finished up in 30 of those years — an impressive 85% win rate for the predictor.

It has been quoted by such venerable sources as U.S. News & World Report. CNN and Money Magazine. The problem is this: It’s a useless indicator, or worse, it’s potentially dangerous to your wealth.

Don’t Waste Your Time On This Meaningless Myth

Let me be blunt. The First Five Days stock indicator is the lowest form of analysis. It is the opposite of cause and effect. This is the type of analysis that looks for any cause to tie to an effect, regardless of logic, and as we shall see, regardless of statistical support.

The indicator is no more valid or useful than predicting the stock market based on Super Bowl winners or groundhog shadows. Here are three reasons why

1. The logic is arbitrary. The raw numbers for this indicator show that the stock market has gone down during the first five days of January 20 times in the last 55 years. In those 20 occurrences, the market finished the year up 10 times and down 10 times.

So, the authors conclude that the market indicator has no predictive value if it starts out to the downside. Looking at the same data, they like the results if the market starts out to the upside, where it has been right 30 out of 35 times. Working in one direction, but not the other, is too arbitrary for me!

If the data don’t fit our hypothesis, then change the hypothesis to fit the data. This is classic curve fitting mentality. Do you want to risk any of your investments based on that logic?

2. The triggering event is not statistically significant. For this indicator, all you need to trigger a yearlong market prediction is any up move for five days. This means that trivial moves in the market could shape your outlook for the coming year.

Suppose after five days the stock market was up only one quarter of a point. This would still trigger the indicator’s prediction for an up year.

What’s the problem with having a move of any magnitude trigger as a measure? A tiny move doesn’t tell us anything about what the market is doing. A small move either up or down is just random — it’s just part of the background noise of the market.

So how do we decide what is meaningful and what is just background noise? One measure that many analysts use is the average volatility of a price movement. Longtime readers know that I use the Average True Range (ATR) of price as a measure of volatility. (In simple terms, ATR measures the average size of the daily range (the high minus the low), while accounting for gaps between bars.)

If we look at the ATR for a five-day move, we would want our trigger to move up or down at least half of the average. Anything less would almost have to be considered random.

With that in mind, your industrious editor dug deep into the details of the First Five Days indicator’s raw data. I calculated the S&P 500 index’s ATR for the last 20 years and checked to see how many of the First Five Days trigger signals could be considered more than random. The answer: Only four!

3. And now — the sample population is too small. When we eliminate the trigger signals that are mere noise, we now only have 12 to 15 triggers of the indicator over the last 55 years. This is not a statistically significant sample to base any predictions on, and this stock indicator is uncovered as just some simplistic curve fitting that doesn’t mean a thing for traders and investors.

There is plenty of good analysis for you to use to help guide your trading and investing decisions. So it makes a lot of sense to throw out the overly simplistic, statistically meaningless stock market indicators like the First Five Days gauge.

You can still use it for cocktail party discussions, but don’t waste any investment money trying to use it to help you make sense of the markets.

Great trading,

D.R.

Today’s TU Tips & Tricks