This month, we leave the world of Washington gridlock for a timely discussion of one of Wall Street’s many maxims of investing – the “January Effect” – which states, “As January goes, so goes the year.” That is, positive stock market returns in January predict positive returns for the rest of the year, and vice versa. With the Standard & Poor’s 500 index up 5 percent last month (its best showing since 1997), the promise of positive returns through the end of the year is alluring, to say the least.

Will the January Effect work this year? Well, if one looks at the fundamentals, there are a number of encouraging signs for the economy that may boost stock returns. Corporate earnings have been largely positive, we avoided a fiscal cliff disaster, housing prices are firming and employment is gradually improving.

But the January Effect doesn’t speculate on underlying causes. It simply looks at the correlation between stock market returns in January and the rest of the year. From 1950 through 2012 the January Effect has correlated with the stock market’s direction for the year with a remarkable 81 percent accuracy (though it has been less accurate in recent years). Average differences in 11-month returns following positive and negative January results exceed 10 percent.

If you want reassurance, there you go. So is a stock market gain for 2013 a certainty?

We don’t think so. We’re not saying that the market won’t continue to rise this year; just that you shouldn’t rely on the January Effect to answer the question. Correlation is not causation.

Investment strategies work until they don’t, and when no one can explain why they worked in the first place, there is reason to be skeptical. Furthermore, although 62 years is a long time, in statistical terms a sample size of 62 is a woefully small data set. If you’ve ever looked at a chart of 1 million flips of a coin, you know that a fair coin can still land heads-up a startling number of times in a row.

Finally, despite its apparent simplicity as a market timing tool, it turns out that investing based on the January Effect doesn’t improve returns. A 2007 paper titled “The Other January Effect: Evidence Against Market Efficiency?” found that despite the indicator’s predictive ability, investing based on the January Effect resulted in inferior returns compared with a passive, buy-and-hold strategy.

Markets are up and investors are feeling optimistic, making the January Effect good fodder for cocktail conversation. But when it comes to actual investing, it’s another reminder that successful investing requires the diligent application of critical thinking skills.


Miles Note:

A quick closing story about how our definition of “money” is changing in the digital age. A few weeks ago, I stopped into a local Kum & Go for coffee. When I went to pay, five people were lined up while two cashiers huddled in front of a single cash register. After a brief interlude, one of the cashiers stepped to another register and announced, “Our POS system is down; if anyone has cash, I can take you here.”

Like Moses parting the Red Sea, a neat digital divide formed. Two of us (apparently) aged 50-plus stepped to the left and pulled out our old-fashioned paper money; the others remained in the original line, meaning, as I took it, that those armed with a debit/credit card saw no need to carry cash. As one who hasn’t left home without a bill in my pocket for decades, it was an eye-opener.

I rather like this new definition of money though, and though I saved a bit of time that day, I look forward to my last visit to an ATM.