Let’s Ignore January’s “First Five Days” Indicator – Again By, D. R. Barton, Jr.

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Some errors just keep repeating themselves… much like the endless time loop in the classic film, Groundhog Day, starring Bill Murray.

Let’s do a little myth-busting today—that savory task of uncovering indicators that don’t indicate what they’re supposed to.

An indicator that gets a lot of press early each year is the “First Five Days” indicator, which holds 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. Rest assured; it just doesn’t work.

Much like Murray’s character, grouchy weatherman Phil Connors tries unsuccessfully to break the time loop in such innovative ways as electrocuting himself and driving off a cliff, this myth will not die.

The reason is simple. At the core of human nature is the desire to understand complex systems in simple terms. The problem is that we tend to apply this simplistic cause-and-effect model to very intricate problems and then expect similar “easy-to-understand” answers.

Interestingly, one good example of this human tendency to try to understand multifaceted issues with simple explanations is the Groundhog Day Weather Indicator. Like the financial markets, weather systems are complex and difficult to predict. But we have devised many simplistic ways to predict the weather, including the infamous Pennsylvania groundhog, Punxsutawney Phil. If he sees his shadow on February 2nd, the presumption is that there will be six more weeks of winter weather.

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

So, let’s look at one of these hyped indicators that you’ll be hearing a lot about over the next week.

January’s “First Five Days”: It’s Talked About Everywhere, but Don’t Bite

Every few years the media takes a break from yapping about New Year’s resolutions and the year’s hottest stock to find different fodder for discussion. For that, they look for anything that will catch your ear or eye.

One early January staple of conversation is the well-known “First Five Days” indicator, which has been popularized by Yale Hirsch’s Stock Trader’s Almanac. I’ve read and heard so much over the last few years in blogs, on CNBC and even in the Wall Street Journal. And before the media gets wound up on this subject again over the next few days, I thought it would be useful for us to see if this indicator has any merit.

For the record, I think the Almanac contains a wealth of useful information. But apparently, you can’t win ‘em all…

As proof of the indicator’s effectiveness, its proponents look at a 73-year record and state that of 47 “First Five Days” that finished up, the stock market finished up in 35 of those years—an impressive 83% win rate for the predictor.

That sounds pretty good. But…

This Meaningless Myth Doesn’t Stand up to Rigorous Analysis

Let me be blunt. The “First Five Days” 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 outcome, regardless of logic, and 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 market has gone down during the first five days of January 26 times in the last 73 years. In those 26 occurrences, the market finished the year up 14 times and down 12 times. No different than a coin toss. So, it only “works” in one direction.

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 whole year to come.

Suppose after five days the 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 an indicator?  A tiny move doesn’t tell us anything about what the market is doi

ng. A small move either up or down is just random—it’s 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. Long-time 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 will want our trigger to move up or down at least half of an average daily move. Anything less would almost have to be considered random.

With that in mind, your industrious writer dug deep into the details of the “First Five Days” indicator’s raw data. I calculated the S&P 500 index’s ATR during the first five days for the last 34 years and checked to see how many of the “First Five Days’” trigger signals could be considered more than random.

The answer: Only 9!

So, we really only get a significant move during the first five days of January about one out of every four years.

3. Lastly, the sample population is too smallWhen we eliminate the trigger signals that are mere noise, we now only have about 18 meaningful triggers of the indicator over the last 66 years. And, only 12 of those are to the upside. This is not a statistically significant sample to base any predictions on, and this indicator is uncovered as just some simplistic curve fitting that doesn’t mean a thing for traders and investors.

There are plenty of meaningful and useful seasonal trends out there. So, it makes a lot of sense to throw out the overly simplistic, statistically meaningless ones like the “First Five Days” indicator, no matter what you hear or read.

Otherwise, you may find yourself waking up listening to “I Got You Babe” on the clock radio for the thousandth time in a row, and that is a recipe for madness.

One last note of caution – The indicator worked last year as an early warning to a down year. This brings another psychological bias into play. We ten

d to assign an excessive amount of meaning to the most recent data points. Don’t fall into this “recency bias” with the “First Five Days” indicator.

You can still toss it around for cocktail party discussions, but don’t waste any money trying to use it to help you make sense of the markets. Let’s put this endless jabber about the “First Five Days” aside and concentrate on things that can really help us grow our wealth, like managing risk and using diversification as an ally.

Great trading and God bless you,

D.R. Barton, Jr.

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