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The January Barometer
Risk can be reduced by responding to The January Barometer. Do not respond to market trends, market P/E ratio, or the Volatility Index.
The January Barometer
Yale Hirsch popularized the January Barometer. Supposedly, the direction of the S&P 500 Index in January is likely to persist for the remaining eleven months of the year.
Average gains derived from monthly S&P 500 Index data validate the January Barometer and show January was by far the best forecasting month:
Average gains derived from monthly Dow Jones Industrial Average data show January was not a good forecasting month. The Dow Jones Industrial Average cannot be used for the January Barometer:
Eleven months seems like an arbitrary period. Therefore, daily S&P 500 Index data were analyzed to determine behavior in negative January Barometer years:
The losses were confined to the middle of the year. A popular Wall Street saying is "Sell in May and go away." A better saying would be "If the January Barometer is negative, start defensive action on the first trading day before April 19 and end defensive action on the first trading day before October 11."
Market trends
Downtrends
It might seem following market trends would be a viable alternative to the January Barometer, but the market has such an upward bias that this is not effective. Trends for the S&P 500 Index from 1/4/1960 through 12/31/2015 were calculated with TRENDS.BAS:
The average downtrends for 5 and 10 box thresholds barely exceeded double the threshold, as would occur in random behavior (#tests). The average downtrend for a 20 box threshold was worse than random.
Death crosses
Another way of determining market trends is with 50-day and 200-day moving averages in the S&P 500 Index. An intersection is called a death cross if the 50-day falls through the 200-day or a golden cross if the 50-day rises through the 200-day.
Hedging by selling on a death cross and buying on a golden cross would have resulted in an annual gain of 0.21 boxes. This is negligible.
Market P/E ratio
Pundits frequently cite the S&P 500 P/E ratio as an inverse measure of market value. This chart shows the ratio is not a useful tool:
Two low and two high ratios are circled. The market rose after the low ratios, but it also rose after the high ratios. Even worse, the highest ratio coincided with a bear market bottom.
Respect successful investors. Warren Buffett noticed the S&P 500 Index roughly parallels nominal GNP, as the chart shows. The market could be overvalued if it has risen faster than the economy for several years. It could be undervalued if it has stagnated for several years during an economic expansion.
The Volatility Index
The Volatility Index (VIX) is designed to measure option buyers' expectations of stock market volatility in the next 30 days. This chart shows the index is not a useful tool:
Two bottoms and two tops in the VIX are circled. The second bottom seemed to forecast a market top and the second top seemed to forecast a market bottom. However, this forecasting ability was not confirmed by the first bottom or the first top.