INVESTMENT NEWSLETTERS
PREDICTING MARKET DIRECTIONS:
THE MYTH OF THE FIVE-DAY INDEX
By Mark Hulbert
Many bullish advisers
today are advancing the
argument that because
the market produced a
sizeable gain over the
first five trading days of
this year, 2002 as a
whole will be bullish.
But these arguments do
not appear to be
grounded in historical
fact. A cautionary tale of
how, over time, certain
beliefs take on a life of
their own.
The stock market rally that began last fall must be on its last legs. Bullish
advisers are scraping the bottom of the barrel in their attempts to come up
with rationales as to why investors should continue betting on it.
Consider one of the arguments that is currently widely cited among the
bullish newsletters that I monitor: Because the stock market produced a
sizeable gain over the first five trading days of this year, 2002 as a whole will
be smartly bullish too.
For example, John McGinley, the editor of Technical Trends, writes that
when the market goes up during the first five days, “it almost always indicates
that the market will go up” during the year.
And Donald Rowe, editor of Wall Street Digest, asserts that “if the first five
trading days of the year are up, the market will be up for the entire year.”
Now, the market did indeed do well over the first five trading days of
January—for instance, the Dow Jones industrial average advanced 1.3% and
the Nasdaq composite index was up over 5%. But as far as I can tell, these
editors’ arguments are not based in historical fact. No significant correlation
exists between the stock market’s behavior over the first five days of January
and its direction for the year as a whole.
This is a cautionary tale of how, over time, certain beliefs take on a life of
their own and therefore become immune to the historical scrutiny that would
show them to be false.
THE GENESIS OF A MYTH
How could so many investment advisers have come to believe in this pattern
that some refer to as the “five-day index”?
As best as I have been able to determine, their belief is derived from a
theory that first began circulating around Wall Street a few decades ago—the
idea that the entire month of January is a reliable predictor of the stock
market’s direction for the entire year. However, it has only been in more
recent years that advisers advanced the notion that the first five days of
January were a good harbinger of the entire month’s direction, and by virtue
of the original theory that had by now become an established part of Wall
Street folklore, that was extended to a forecast of the year as a whole.
Unfortunately, however, neither the original theory nor its more recent
amendment can withstand scrutiny. Consider first the ability of the entire
month of January to foretell the remainder of the year. Over the last 105
years, as measured by the Dow Jones industrial average, there were 67 years
in which January’s direction correctly foretold the stock market’s direction
over the subsequent 11 months—a success rate of 64% (Figure 1).
Because this success rate is above 50%, this may appear to be impressive.
But it is not. Because the stock market goes up over the long run, we know
that the market will rise during the majority of Januarys as well as during
most years. This may create the illusion that January’s direction is predicting
Mark Hulbert is editor of the Hulbert Financial Digest, a newsletter that ranks the
performance of investment advisory newsletters. It is published monthly and is located at
5051B Backlick Rd., Annandale, Va. 22003; 703/750-9060; www.hulbertdigest.com.
This column appears quarterly and is copyrighted by HFD and AAII.
34
AAII Journal/February 2002
INVESTMENT NEWSLETTERS
to subject
their arguments to even
a modicum of
historical
70%
scrutiny.
But perhaps
60%
the biggest
50%
reason why
these false
40%
notions
30%
continue to
persist in
20%
investors’
10%
minds is the
mere fact that
0%
they have
First 5 days of January
Month of January
Percent of time market
been repeated
correctly foretell market
correctly foretells market
rises from February
so many
direction for rest of month direction for rest of year
through December
times for so
many years.
Investors,
therefore,
have come to assume that these
the full year’s course. But we also
only 49 occasions did the stock
notions are solidly based in historical
know—if you stretch back to your
market’s direction during the first
fact, and thus they never get around
educational years and Philosophy
five trading days correctly foretell
to demanding proof that they are.
101—that when two events appear
equities’ direction over the rest of
to be acting in constant conjunction
the month. You would have done
THE PLAUSIBILITY RULE
with each other it does not necessarbetter simply by flipping a coin.
ily mean that one is causing the
So the five-day index is a dismal
The lesson for investors to draw is
other. Otherwise, as Scottish phipredictor of a month that itself
to adopt an attitude of healthy
losopher David Hume reminded us
possesses no genuine forecasting
skepticism toward all the truisms
several centuries ago, the fact that
ability.
that get repeated daily without
day always follows night would
How could these notions that are
question.
mean that night is the cause of day.
so palpably false have gained such
While it may not be practical to
To be genuinely impressive,
currency?
subject every last thing we hear to a
January would have to do even
One factor is sloppy statistics.
full and complete statistical scrutiny,
better than a simple bet every
Several of the studies that have been
there is at least one helpful rule of
February 1 that the market would be
cited over the years in their support
thumb: Always ask yourself if there
higher in 11 months’ time. And it
were guilty of a simple error: They
is a plausible explanation for why an
does not: Over the last 105 years
correlated the direction of the
alleged pattern should exist in the
you would have been right 68 times
market during January with the
first place. And you should give the
by making such a simple bet, one
direction of the market over the
greatest scrutiny to those notions
more than if you had bet according
entire 12 months from New Year’s
that seem least plausible.
to January’s direction (see Figure 1).
through December 31. That is about
The five-day index definitely fails
as fair as allowing you to continue
such a plausibility test. Why should
THE FIRST FIVE TRADING DAYS
placing bets at the racetrack even
the first five trading days of the year
after the race has started.
possess any special forecasting
That is devastating enough to the
Another factor that accounts for
ability? The lack of any plausible
bull’s current argument, but now
the popularity of these patently false
explanation for why this should be
consider the notion that January’s
notions is advisers’ desire to believe
would have raised a red flag in any
first five trading days are a good
in this rally. That need to believe is
case, and now we know that this
predictor of the full month’s direcso strong that they have suspended
tion. Over the last 105 years, on
their skepticism and therefore failed
skepticism is completely justified. ✦
FIGURE 1. THE DOW’S SUCCESS RATES FOR PREDICTING THE MARKET’S DIRECTION
THE DOW JONES INDUSTRIAL AVERAGE: 1897 TO 2001
AAII Journal/February 2002
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