January Barometer Stock Market Effects: Can January Foretell The Rest of the Year?

The January Barometer is a seasonal trading strategy that worked over many decades. While the traditional January Effect seems to be arbed away, the January Barometer has worked well for many decades. This is the January effect that works – the January Barometer. What is it all about? Let’s find out:

The gain in January determines the average gain for the next 11 months: If the S&P 500 declines in January, the average percentage change for the next eleven months is 3.3%. If the S&P 500 rises during January, the average percentage change in the next 11 months is 10.3%. This is the new January Barometer Stock Market Effect.

January Barometer – the January effect that works

We came across the January Barometer for the first time when we read the books from Victor Niederhoffer in the 1990s. He was one of the first quants to use systematic backtesting for all his trading strategies. 

On pages 279-280 in The Education of a Speculator, Victor Niederhoffer explains his version of the January effect and sets forth that the gain in January determines the average gain for the next 11 months. The trading rules are like this:

• If the S&P 500 rises between January 1 and January 31, it is believed that the market will perform positively for the remainder of the year.
• Conversely, if the market performs poorly in January, it is believed that the remainder of the year will do the same. 

Pretty simple rules!

Victor Niederhoffer’s book is old – published in 1997. Does Niederhoffer’s hypothesis still hold?

It does:

The equity curve below is 100 000 compounded when January showed a decline (entry is on the close of January, and the exit is at the close of December 11 months later), from 1960 until today:

The first real drawdown happened in 1974, and the strategy never really recovered after that. The decade-long bull market of 2010-2020 made the strategy recover somewhat.

The reason for the poor performance is that during losing years, S&P 500 drops almost 16% on average, while the winning years rise only 13%. Hence, the risk and reward is poor.

But when January is positive, the equity curve improves substantially:

Quite a difference, to put it mildly. When January is up, the win ratio is 83%. When January is down, the win ratio drops to 62%. When January is up the average gain the rest of the year is 10.3% without even considering reinvested dividends (compared to only 2.6% when January is down). 

The reason for the good performance when the January Barometer flashes a buy signal, is that losing years only drop 8% on average, while the winning years rise almost 15%.

The reason why this strategy seems to work is because of the occasionally large losers when January is down. For example, it happened in 1974 and 2008, two years which went on to fall substantially the rest of the year. When you avoid big drawdown you can start compounding from a higher level.

If you want to have the Amibroker or Tradestation code for the January Effect (and much of the code for our free trading strategies), please press this link:

Why does it work?

The January Barometer works well (most likely) because the market is in a bull market. When the end of January is higher than the close of December, it’s only three occasions where the close was below the 200-day moving average.

The 200-day moving average is a fantastic filter to determine bull and bear markets. As long as the close is above the 200-day moving average, it’s a bull market, and it’s a bear market if it’s below. 

Critique of the January Barometer

While the January Barometer is popular among some traders, critics argue that it is not a reliable predictor of the market’s performance and that similar phenomena have not been as strong in other global equity markets.

That might be true, but not all markets are equal. 

Conclusion: the January Barometer has worked well (so far)

The January effect presented in this article is not bulletproof (of course): It was out of the market in both 2020 and 2021 (in both years the S&P 500 went on to rise substantially). Nonetheless, it has had a fairly good prediction rate over the last 60 years. It gets a positive signal about 60% of the time. 

Who invented the January Barometer?

The idea of the January Barometer was first devised by Yale Hirsch, creator of the Stock Trader’s Almanac in 1972. This is an “almanac” we strongly recommend to try. It has a lot of interesting info. Not all is useful, but certainly interesting and entertaining. 

FAQ:

– Has the traditional January Effect vanished, and is there an alternative?

Yes, the traditional January Effect seems to have disappeared, but an alternative January effect has been identified. This new approach involves the gain in January determining the average gain for the next 11 months.

– What happens if January shows a decline in the alternative January effect?

If the S&P 500 declines in January, the average percentage change for the next 11 months is 3.3%. Conversely, if January shows a rise, the average change is 10.3%.

– Why does the strategy work differently for positive and negative January performances?

The strategy’s effectiveness varies due to occasionally large losers when January is down. Avoiding significant drawdowns allows for compounding from a higher level.