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Some errors just keep repeating themselves… much like the endless time loop in the classic Bill Murray film "Groundhog Day."
Let's do a little myth-busting today – that savory task of uncovering 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, which holds that the direction of the first five trading days of the year is a valid predictor of the direction of the market for the remainder of the year. Rest assured, it just doesn't work.
Like Murray's character, grouchy weatherman Phil Connors, who tries unsuccessfully to break the time loop by electrocuting himself and driving off a cliff – this myth just will not die.
The reason is simple: At the core of human nature is the desire to understand complex systems in simple terms. The problem is we tend to apply this simplistic cause-and-effect model to very intricate problems and then expect similar easy-to-understand answers.
Interestingly, one good example of this human tendency to try to understand multifaceted issues with simple explanations is the Groundhog Day weather indicator. Like the financial markets, weather systems are complex and difficult to predict, but we've devised many simplistic ways to predict the weather, including the infamous Pennsylvania groundhog, Punxsutawney Phil. If he sees his shadow on Feb. 2, the presumption is that 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 any 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 these hyped indicators that you'll be hearing a lot about over the next week…
January's First Five Days – It's Popular, but It Ain't Useful
Every few years the media takes a break from yapping about New Year's resolutions and the year's hottest stock and looks for different fodder for discussion. For that they look for anything that will catch your ear or eye.
One early January staple for conversation is the well-known First Five Days indicator, which has been popularized by Yale Hirsch's "Stock Trader's Almanac." I've read and heard so much about it in blogs, on CNBC, and even in The Wall Street Journal. And before the media gets wound up on this subject again over the next few days, I thought it would be useful for us to see if this indicator has any merit.
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For the record, I think the almanac contains a wealth of useful information. But apparently, you can't win 'em all…
As proof of the indicator's effectiveness, its proponents look at a 66-year record and state that of 42 first five days that finished up, the stock market finished up in 35 of those years – an impressive 83% win rate for the predictor.
That sounds pretty good. But…
This Meaningless Myth Doesn't Stand Up to Rigorous Analysis
Let me be blunt. The First Five Days indicator is the lowest form of analysis. It is the opposite of cause of and effect. This is the type of analysis that looks for any cause to tie to an outcome, regardless of logic, and regardless of 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…
About the Author
Nationally recognized technical trader. Background in engineering, system designs, and risk reduction. 26 years in the markets.