Some errors just keep repeating themselves… much like the endless time loop in the classic Bill Murray film “Groundhog Day.”
Let’s do a little myth busting today – that savory task of uncovering indicators that just don’t indicate what they’re supposed to.
An indicator that gets lots 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.
Like Murray’s character, grouchy weatherman Phil Connors, who tries unsuccessfully to break the time loop by electrocuting himself and driving off a cliff — this myth just 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 – 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 2, the presumption is that 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 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 Popular, But it Ain’t Useful
Every few years the media takes a break from yapping about New Year’s resolutions and the year’s hottest stock and look for different fodder for discussion. For that they look for anything that will catch your ear or eye.
One early January staple for 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 about it 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 66-year record and state that of 42 “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 24 times in the last 59 years. In those 23 occurrences, the market finished the year up 12 times and down 12 times.
So, the authors conclude that the 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” 31 out of 36 times. Working in one direction but not the other is too arbitrary for me!
If the data don’t fit the hypothesis, then change the hypothesis to fit the data. This is classic “curve fitting” mentality. Do you want to risk any of your money 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 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 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. 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 would 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 30 years and checked to see how many of the “First Five Days” trigger signals could be considered more than random. The answer: Only 8! So we really only get a significant move during the first five days of January about one out of every four years
3. And lastly – the sample population is too small. When 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 is plenty of good analysis for you to use to help guide your trading and investing decisions. Our 10-Minute Millionaire systematic approach is certainly a good one to start with.
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 the row – and that is a recipe for madness.
One last note of caution – the indicator worked last year. This brings another psychological bias into play: we tend 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 for cocktail party discussions, but don’t waste any money trying to use it to help you make sense of the markets. So let’s put this endless jabber about the “First Five Days” aside and concentrate on things that can really help in the markets over the long term.
So we’ll continuing buying strong stocks on pullback as long as the Trump Growth Narrative and associated economic expansion persists.
Great trading and God bless you,
D.R. Barton, Jr.