Does a Strong Start Make 2018 a Sure Winner for Stocks?

The stock market has jumped out to an impressive start in 2018. The Dow Jones Industrials (^DJI 0.42%), S&P 500 (^GSPC 0.70%), and Nasdaq Composite all went up during each of the first four days of the year, with gains of between 2% and 3.5% for the holiday-shortened week.

Many investors believe in what's known as the January effect, a seasonal indicator that suggests that the direction that the market goes early in the year serves as a good guide to how the entire year will go. By that measure, a favorable first week of January bodes well for the prospects for a 10th straight year of bull market gains. Behind every such seasonal indicator, however, there's a combination of fact and folklore that doesn't always guarantee success. To understand the January effect fully, you need to look at its origins and its track record.

Image source: Getty Images.

Where the January effect came from and what it means

The January effect phenomenon comes in different forms, with different investors believing slightly different versions of the story. For some, the January effect comes only in the first few trading sessions of the New Year. According to that version of the theory, investors often sell out of stocks late in the year, especially in companies that have done poorly and therefore generated tax losses for their shareholders. Then, during the first week of January, they turn around and reinvest that money in other stocks. By that version of the theory, 2018 is already destined to be a winning year simply by virtue of the fact that market benchmarks rose so sharply between Jan. 2 and Jan. 5.

Other versions of the January effect look at the entire month as a signpost for how the year will go. This theory incorporates some of the year-end activity that the version above mentions, but the longer time period also gives investors a chance to see how momentum from the previous year translates during the current year. Advances set a positive tone for market participants, while reversals tend to raise anxiety levels that can persist throughout the year. If you subscribe to this version of the January effect theory, then the jury's still out whether 2018 will be a winner.

Why the January effect has been worthless recently

The problem with the January effect is that it hasn't been particularly accurate in recent years in predicting the course of the stock market throughout the ensuing 11 months. Here's its track record over the past 10 years.

Data source: Yahoo! Finance.

As you can see, the January effect metric has had an exactly 50% record of success over the past decade. That makes it the same coin-flip proposition that most people would expect from any other random distribution of events.

Long-term investors understand that focusing on time periods as short as a month or even a year can lead to major mistakes in strategy. On one hand, the stock market has demonstrated an ability to rise consistently over extremely long periods of time, offsetting the downward impact of bumps along the way. At the same time, stocks have been higher in 14 out of the past 15 years, and many think it's long overdue for the market to revert toward the mean with a losing year in 2018.

Don't count on the January effect

The January effect is a simple and attractive-sounding rule, but unfortunately, it doesn't hold up to empirical evidence. Each year is different, and although many investors will celebrate early year gains, there's no guarantee that the market will be able to build on those advances throughout 2018 and beyond.

The better course for investors to follow is to come up with a long-term strategy that you can use comfortably during good markets and bad. That way, you won't need to give undue weight to whether the market happens to rise or fall during the first few days of the year.