Can January predict the year's trends? Historical analysis since 1920

In this article, we focus on a phenomenon known as the “January barometer,” a concept that the stock market’s performance in January can provide significant insight into the rest of the year. It is commonly observed that if the market performs positively during January, this could signal a good year, while a negative performance could signal difficulties in the months ahead. Through today’s analysis, we will evaluate whether this theory is well founded and whether there are any patterns to exploit. To do this, we will use the Dow Jones Industrial Average as a stock index.

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The Dow Jones stock index and the January barometer: analysis of over 100 years of data

The Dow Jones Industrial Average ($INDU) is one of the longest-running stock indices. Created in 1896 by Charles Dow, this index was designed to reflect the performance of the 30 most influential US companies, representing a mix of different sectors, including technology, finance, consumer goods and services.

For our study on the January barometer, we chose to use this index since we have access to its historical data starting from 1920. This long series of data allows us to analyze the performance in the month of January in detail and to identify any patterns recurring.

Test with trading strategy that buys after a positive January

For our January barometer study, we will use a monthly time frame. The strategy involves opening a long position at the opening of the next monthly bar only if the month of January closes with a positive performance. Positions will be closed at the opening of the January bar of the following year, as our objective is to evaluate the market performance over the remainder of the year. In this way, we can observe whether a positive performance in January translates into favorable returns in the following months.

We will dedicate a capital of 1,000,000 dollars for each operation, for purely academic purposes, considering that the index is currently worth around 40,000 points. This approach allows us to have greater granularity in positions and manage invested capital more effectively.

In Figure 1, an example of this type of trade is shown, highlighting the entry and exit points according to our strategy.

Figure 1. Example of a Dow Jones trade following a positive January.

Analyzing the results obtained, we can observe that the equity line, as shown in Figure 2, highlights an overall growth, with a significant drawdown in the first years of backtest, corresponding to the 1929 crisis. Despite this initial decline, the subsequent trend of the equity line has been consistently positive.

From the Total Trade Analysis, presented in Figure 3, we note that the average trade is approximately $70,000. This value represents 7% of the capital dedicated to each operation. This is not an extraordinary result, but it is in line with the average returns of the stock markets.

Figure 2. Equity line of the Dow Jones strategy that buys only when January closes positive.

Figure 3. Total Trade Analysis of the Dow Jones strategy that only buys when January closes positive.

Counter test: test with a trading strategy that buys after a negative January

In order to further evaluate the validity of the January barometer, we adopt the strategy of opening the position following a negative performance in the first month of the year.

From the equity line shown in Figure 4, we can see that the performance was very positive in the early years of the backtest, particularly during the 1929 crisis. Subsequently, the equity line showed a rather flat trend for a long period, before to recover in more recent years.

From the Total Trade Analysis, shown in Figure 5, we note that the average trade is 65,000 dollars, a value overall similar to that seen previously. This suggests that, in fact, January’s performance did not significantly impact market performance.

Figure 4. Equity line of the Dow Jones strategy that buys only when January closes in the negative.

Figure 5. Total Trade Analysis of the Dow Jones strategy that buys only when January closed in negative.

Analysis of results: the effect of outliers due to extreme historical events

In the analysis of the results obtained, the presence of anomalous values, or outliers, clearly emerges, which can influence the validity of our conclusions. As shown in Figure 6, relating to the profits and losses of the first backtest, the data highlights significant outliers in the first years considered, corresponding to extreme historical events such as the 1929 crisis. This pattern is also repeated in the backtest with negative January, highlighted in Figure 7, where outliers continue to appear, suggesting that results from those periods may not be representative of normal market conditions.

Figure 6. Results of the individual trades of the strategy with positive January.

Figure 7. Results of the individual trades of the strategy with negative January.

To obtain more comparable data and a more accurate evaluation of the strategy, we therefore proceed by focusing on the results since 1940. This choice allows us to exclude significant outliers and analyze performance in a more stable market context.

Test with data from 1940: how reliable is the January barometer?

By focusing on results since 1940, we can see how the performance of the January barometer translates into significant average returns. As shown in Figure 8, when January closes with a positive performance, the average trade turns out to be particularly interesting, recording a value of 95,000 dollars, equivalent to approximately 9.5% of the capital invested for each operation. This suggests that a positive January is associated with significantly favorable returns over the course of the year.

In contrast, looking at the results after a negative January, as illustrated in Figure 9, the situation changes significantly. In this case, the average trade is drastically reduced to $37,000, highlighting a much more modest return. These results support the idea that January performance can have a significant impact on the year’s results, making clear the importance of this month as an indicator of future trends in the stock market.

Figure 8. Total Trade Analysis, since 1940, of the strategy that buys only on a positive January.

Figure 9. Total Trade Analysis, since 1940, of the strategy that buys only in negative January.

Conclusions: is January a reliable indicator of stock index trends?

In conclusion, the analysis conducted highlighted the importance of outliers and their significant impact on the backtest results. Extreme events such as the 1929 crisis have distorted historical performance, suggesting that their inclusion in the analysis may be suboptimal. By excluding these outliers, we were able to gain a clearer and more realistic view of the validity of the January barometer.

However, the presence of outliers also offers us excellent food for thought. In a strategy without exit mechanisms, such as stop losses, it is essential to be aware of the risk of incurring substantial losses on individual trades.

Finally, through this article, we have demonstrated that the January barometer presents interesting investment opportunities, at least this has been the case since 1940. It will be interesting to observe whether this trend will be confirmed in the years to come. That’s all for today!