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January Barometer of the Stock Market

USA Today published a story yesterday entitled "January stocks on track to set a positive tone for 2011." The story, by Adam Shell, stated:
The month of January is akin to a crystal ball for stock market forecasters on Wall Street. And for good reason: How stocks fare in the first month of the year often foreshadows the direction of stocks for the rest of the year.
The pattern is simple. If stocks rise in January, the odds of the market being up at year's end are high, says the Stock Trader's Almanac 2011, which dubs this predictive tool the January Barometer. The accuracy rate is impressive: There have been only seven major errors since 1950, for a success rate of almost 90%, the Almanac says.
I always get a little skeptical when I hear "crystal ball," but applying the "January Barometer," the stock market is currently up 1.5% through the first seven trading days. Does that mean it's time to buy? Before you jump back in to the stock market based on this, consider the following facts.

Humans love patterns and hate randomness
First of all, the human desire we all have to feel we are in control causes us to detest randomness. To counter this detested and unavoidable randomness, we seek and find all sorts of past patterns. Those that seemed to be predictive of the stock market in the past, inevitably fail us going forward. Just a couple of the most famous include:

Dogs of the Dow
Super Bowl Winners
The mother of all stock market patterns, and my personal favorite for its absurdity, was found to be Butter Production in Bangladesh. This would have proven to be hotter than the Dogs of the Dow if anyone could have come up with an explanation for the cause of this pattern.

What is important to recognize, is that if you compare the stock market to 1,000 random events, you will on average come up with one series that gives you a 99.9% correlation. Unfortunately, it offers no predictive ability whatsoever.

Cheating in these numbers?
Beyond pattern finding, it looks like there are a couple of problems with this data, though I couldn't find a media contact at the Almanac.

For starters, note that the barometer predicts a bit of the past as well as the future. As an example, let's say our hypothetical year starts out with a great January and a market up ten percent. Over the next eleven months, let's say the market drops by nine percent and finishes the year up one percent. That counts as a successful year for the so called barometer, even though the investor who relied on it lost money.

And secondly, note that the wording says only seven "major" errors. I would have liked to ask what the definition of "major" is. Is being down three percent considered a minor or major error?

My advice
Jason Zweig, writer of the Intelligent Investor at The Wall Street Journal, told me "it's a very frightening feeling to know that we can't predict the future." He noted that though we want to believe that we are in control, that control is usually an illusion.

One of the keys to successful investing is possessing the wisdom of knowing we don't know. So far this year, I've reduced stock exposure in my portfolio. Not because I'm betting against the January Barometer. I'm just rebalancing due to my gains in 2010. Rebalancing can make any investor a true contrarian, as fund flows typically chase performance.

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