Old saws about the future direction of share prices are comforting to recite. But as investment guides, most are not to be trusted.
If you "Sell in May and go away. Don't come back 'til St Leger's Day", you would miss holding shares during August, the year's third best investment month.
Do "Bull Market bashes end with October crashes?" In fact, there have been more large increases in share prices during October than large decreases. Over the long-term, October has been profitable despite headline-making events in 1929 and 1987.
"As January goes, so goes the year" is another member of the club. Much of what is written about this trend is either misleading or out-and-out wrong.
Some analysts include January's performance in their yearly total, thereby loading the dice in their favour. Predicting a full year price rise after January gains eight per cent provides an eight per cent head start toward being right. It may be great for their predictive accuracy but painful for investors who commit new funds on February 1st, based upon this advice.
A more accurate way to keep score is to forecast the direction of prices during the next 11 months from January price shifts.
When thinking about January’s predictive qualities, it is worth keeping in mind that the UK stock market rises 67 per cent of the time over the long-run between February to December regardless of what happened in January.
This trend has run for a century.
The likelihood of a February to December gain increases to 72 per cent following a January advance. Statistically, it “proves” the January Rule works but on a practical basis, it is a minor success.
On the downside, if shares decline in January, the likelihood of a rise in February to December slips to 48 per cent. Here too, the data offers no practical help to investors. You can predict the likelihood of a further fall in the next 11 months just as accurately by flipping a coin.
To put January’s predictive prowess into perspective, consider this. Prices rise in the next 11 months 74 per cent of the time following a February or August gain.
But the January Rule’s usefulness can be improved by analysing historical data in a different way. The relationship between January and the rest of the year is complex. It is not simply a case of January up - rest-of-year up, or January down - rest-of-year down.
Big January price declines occasionally occur. History teaches they are frequently followed by disappointing returns for the rest of the year and should be treated as an important early-warning signal.
There were 11 occasions since the end of World War One when the UK stock market declined in January by -3.12 per cent or more. Prices rose in the next 11 months just four times, a 36 per cent success rate.
Two of those four gains were tiny. Shares advanced by just +0.27 per cent in February to December 2000 after an eight per cent drop in January. They gained just +0.07 per cent in the aftermath of a big January decline in 1952.
The 11-month trend improves in lock-step with January improvements. There were nine other years when shares dipped in January by a smaller amount, within a range of -0.12 per cent to -3.11 per cent. Prices rose in the next 11 months five times. The number of years within this group is small but for those who are statistically inclined, prices rose 56 per cent of the time within this group.
If January declines by less than -0.12 per cent or rises by any amount, the likelihood of a gain in the next 11 months increases to 72 per cent. This figure is slightly stronger than it appears to be. The relationship did not work well in the 1920s. Since 1930, shares in this group rose in 42 out of 55 years, a 76 per cent success rate.
As far as 2006 is concerned, the FTSE-All Shares index gained almost three per cent in January. Prospects look good for the rest of the year for those willing to trust the January Rule. But keep in mind that when it comes to the January Rule, discretion is the better part of valour.
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Book Review By David Schwartz – “Technical Analysis From A to Z”
If you would like to learn more about Technical Analysis or charting, a great book to turn to is Technical Analysis From A to Z by Steven Achelis (publisher: Irwin Professional Publishing).
I have read dozens of books in this fascinating field. This one is, by far, the best of the batch. It is short, easy to read and informative, the perfect introductory book for the novice. But it is detailed enough to interest knowledgeable investors seeking to refresh their memories about a specific technical indicator.
Achelis takes his reader through the field of charting, discussing dozens of different tools used by technical analysts. Each description runs two or three pages giving readers an idea about how the indicator is calculated and used.
It is an easy read and an important reference book, well worth the time you will spend with it. Click here to order or visit the Book & Gift Shop for the full range of London Stock Exhange gifts.
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