Does it predict what is likely to happen next?
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In our daily lives, we are presented with many situations where we need to make a decision without having all of the information. To help us stay safe and healthy, our caveman’s brains use mental shortcuts to help us solve problems and make hundreds of small judgment decisions every day. For example:
We know we shouldn’t walk into a dark alley, particularly alone.
We trust and are more influenced by authority figures, such as news channel anchors.
We try and find patterns in random events, such as guessing the sex of a baby.
These mental shortcuts are what psychologists call cognitive biases. By using these cognitive biases, our brains are able to make mostly correct decisions while expending minimal effort.
When it comes to investing, our brain utilizes similar decision-making biases to help simplify the complex. Mental shortcuts, such as rules of thumb, common wisdoms, and catchy phrases can make investing seem easier. But easier doesn't guarantee better results.
Markets, which often reflect all known (and sometimes unknown) information, trade on actual fundamentals, not age-old adages.
An old saying on Wall Street is, "As goes January, so goes the year." The idea is that if the stock market does well in January, it is a sign of positive returns for the rest of the year. Similarly, if the stock market fares poorly during the first month of the year, then these negative results are likely to persist through the rest of the calendar.
Seems plausible after 2022's terrible stock market performance. In fact, the old adage was spot-on last year! But don't be fooled by recent memory (another type of cognitive bias). These are the types of years that breathe new life into these age-old adages. Instead, let's use history as our guide.
The table below uses monthly return data for the S&P 500 Index going back to the start of 1992. This data encompasses bull markets, bear markets, bubbles, crashes, and everything in between. In the table, we plot the month of January's return on the horizontal axis, while we plot the full year's return on the vertical axis. We use this format to help us better understand if January's monthly return really does have predictive power for the remainder of the year.
Based on S&P 500 Index. Source: Standard & Poor’s
Since 1992, January's monthly return was positive and the full year’s return was positive 42% of the time. However, when January’s monthly return was negative, the full year’s return was also negative just 16% of the time. These two contradictory stats prove that January’s return does not have predictive power over what may happen the rest of the year for the stock market.
But what explains why January’s monthly return and the full-year return are positive so often?
Stocks tend to be positive more often than they are negative, historically by roughly a 2-to-1 ratio. This makes sense because we know the long-term history of stocks has been positive. In fact, our data set shows that 71% of the full-year returns have been positive. The reason we recognize some sort of pattern in the data is because of those pesky cognitive biases—our minds are tricking us into believing something that actually isn’t there! And it happens frequently enough to keep us believing.
So, the next time you hear, “As goes January, so goes the year”, “Sell in May and go away”, or about the seasonally generous “Santa Claus Rally” just remember that it’s your mind playing tricks on you. Just don’t let it play tricks on your money, too.
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value-weighted index with each stock's weight in the Index proportionate to its market value.
Wells Fargo Advisors did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The report herein is not a complete analysis of every material fact in respect to any company, industry or security. The opinions expressed here reflect the judgment of the author as of the date of the report and are subject to change without notice. Any market prices are only indications of market values and are subject to change. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.
Past performance is no guarantee of future results. 0123-03970