I’ve read and heard so much lately about the First Five Days Indicator in blogs, on CNBC, and even in the Wall Street Journal that I thought it would be useful for us to revisit this persistent myth.

Below is the reprint of that article in its entirety that I wrote in this same space three years ago. I think it explains very well the myth of the first five days of the year indicating market direction for the year.    

Dismantling the First Five Days Indicator (reprinted from January 21, 2009)

Let’s do a little myth busting today—that savory task of uncovering another of the indicators that just don’t indicate what they’re supposed to. An indicator that gets lots of press early each year is the First Five Days indicator. Rest assured it just doesn’t work.

At the core of human nature is the desire to understand complex systems in simple terms. This human desire produces a problem though: we tend to apply this simplistic cause and effect model to very intricate problems and expect similar, easy-to-understand answers.

One good example is the Groundhog Day Indicator.  Like the financial markets, weather systems are complex and difficult to predict.  In spite of that reality, we have devised some simplistic ways to predict the weather, including the infamous groundhog, Punxsutawney Phil from Punxsutawney, Pennsylvania.  If he sees his shadow on February 2, there will be six more weeks of winter weather.

Because we like simple explanations, we are more than willing to believe cause-and-effect explanations that really don’t make logical sense.

Maybe that’s why there are so many stock forecasting tools that use shaky logic and even shakier statistics to predict what will happen in the market in the days and months to come.

So let’s look at one of the most hyped indicators this week…

January’s First Five Days—It’s Popular, But It Ain’t Useful

Many market watchers and analysts are looking at the well-known First Five Days indicator, which has been popularized by Yale Hirsch’s Stock Trader’s Almanac.

For the record, I think the almanac contains a wealth of useful information.  I keep one on my desk and gave two as Christmas gifts to friends and family.  But back to our specific indicator…

The First Five Days indicator holds loosely that the direction of the first five trading days of the year are a valid predictor of the direction of the market for the remainder of the year.

As proof of the indicator’s effectiveness, its proponents look at a 59-year record and state that of 36 First Five Days that finished up, the stock market finished up in 31 of those years—an impressive 89% win rate for the predictor.

It has been quoted by such venerable sources as The New York Times, U.S. News & World Report, CNN and Money Magazine.  Nevertheless, it’s a useless indicator, or worse, it’s potentially dangerous to your wealth.

Don’t Waste Your Time on This Meaningless Myth

Let me be blunt.  The First Five Days indicator is the lowest form of analysis.  It is the opposite of cause and effect.  This is the type of analysis that looks for any cause to tie to an end effect, regardless of logic, and as we shall see, regardless of (supposed) statistical support.

The indicator is no more valid or useful than predicting the stock market based on Super Bowl winners or groundhog shadows.  Here are three reasons why:

1. The logic is arbitrary.  The raw numbers for this indicator show that the market has gone down during the first five days of January 23 times in the last 59 years. In those 23 occurrences, the market finished the year up 11 times and down 12 times.

So, the authors conclude that the indicator has no predictive value if it starts out to the downside.   Looking at the same data, they like the results if the market starts out to the upside where it has “been right” 31 out of 36 times.  Working in one direction but not the other is too arbitrary for me!

If the data doesn’t fit our hypothesis, then change the hypothesis to fit the data.  This is classic “curve fitting” mentality.  Do you want to risk any of your money based on that logic?

2. The triggering event is not statistically significant.  For this indicator, all you need to trigger a yearlong market prediction is any up move for five days.  This means that trivial moves in the market could shape your outlook for the coming year.

Suppose after five days the market was up only one quarter of a point.  This would still trigger the indicator’s prediction for an up year.

What’s the problem with having a move of any magnitude trigger an indicator?  A tiny move doesn’t tell us anything about what the market is doing.  A small move either up or down is just random; it’s just part of the background “noise” of the market.

So how do we decide what is meaningful and what is just background noise?  One measure that many analysts use is the average volatility of a price movement.  Long-time readers know that I use the Average True Range (ATR) of price as a measure of volatility.  (In simple terms, ATR measures the average size of the daily range, the high minus the low, while accounting for gaps between bars.)

If we look at the ATR for a five-day move, we would want our trigger to move up or down at least half of the average.  Anything less would almost have to be considered random.

With that in mind, your industrious writer dug deep into the details of the First Five Days indicator’s raw data.  I calculated the S&P 500 index’s ATR during the first five days for the last 25 years and checked to see how many of the First Five Days trigger signals could be considered more than random.  The answer: only 7 out of 25!

3. The sample population is too small.  When we eliminate the trigger signals that are mere noise, we now only have 13 to 16 triggers of the indicator over the last 55 years.  This is not a statistically significant sample to base any predictions on, and this indicator is uncovered as just some simplistic curve fitting that doesn’t mean a thing for traders and investors.

There is plenty of good analysis for you to use to help guide your trading and investing decisions.  So it makes a lot of sense to throw out the overly simplistic, statistically meaningless ones like the First Five Days indicator.

One Note of Caution

The indicator worked last year (2008) but be aware of a psychological bias about recent events: we tend to assign an excessive amount of meaning to the most recent data points.  Avoid falling into this trap with the First Five Days indicator.

You can still use it for cocktail party discussions, but don’t waste any money by trying to apply it to help you make sense of the markets.  Let’s put this endless jabber about the First Five Days aside and concentrate on things that can really help in the markets over the long term. 

Back to 2012

In addition to the well-reasoned dismantling of the First Five Days myth from the article three years back, here’s another blow against the indicator’s seeming cause and effect:  since their inception, worldwide stock markets have been in an uptrend.  Populations have grown, economies have expanded, and asset classes have appreciated.  These factors have given an upward bias to stock markets.  So market movement in the first five days of the year is not a useful indicator, just part of an equation that we already understand—in general markets go up.  This is a known result.  At least until the nature of worldwide expansion changes, this will remain the case.

For the curious, the indicator was "wrong" last year but “right” in 2009 and 2010.

Next week we’ll look at a distant cousin of the First Five Days indicator that actually is useful.  Until then…

Great Trading,
D. R.

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