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At the end of every January there is an onslaught of articles talking about the old adage, “as goes January, so goes the year.” The translation is that the performance in January is a good indicator of how the year will turn out.
Instead of our usual weekly market commentary (with the recent holidays and lack of market volume, there is little to report on), we thought we’d take some time out to debunk this myth.
Let’s set up the basics: using S&P 500 index data going back to 1951, we can calculate that in 75% of years, the directional return – positive or negative – from the year mirrored the directional return of January. At first blush, that sounds very convincing. Unfortunately, it turns out not to be very actionable.
Why not? We’ll use an analogy. Let’s pretend we’re flipping a coin 12 times in a row. We start our score at 0. For every heads we add 1 to our score and for every tails we add -1. In our first flip, the coin comes up tails, making our score -1. This -1 says nothing about how the coin will turn up in the future, but what it does give us is information about what we can expect our score to be by the end of the game. Given that the coin flips are random, over the next 11 flips we are just as likely to get heads as we are tails, and so our expected score is going to be the -1 we currently have. So because the first coin flip was negative, we can expect to have a negative score at the end of the game. That is, until the end of the second coin flip, where we will learn a little more about where we stand.
So while our first coin flip gave us information about the expected final score, it told us nothing about the next 11 coin-flips themselves. Those were totally random.
That is, more or less, the same issue with the January adage. A strong January gives the full year’s return a solid head start, but it says nothing about performance in the following 11 months.
What’s a simple way to test this? We can look at the probability that February through December is positive given that January was positive. This is known as a conditional probability and allows us to account for the information we know at the end of January. What is this probability? Close to 70%.
If that seems high it is because the other shoe hasn’t dropped. We forgot to account for the fact that markets, historically, have tended to go up. In fact, the raw probability that February through December was positive over the same time frame is 75%.
In other words, there is no extra information in January’s return that helps us forecast February through December. And nor would we expect there to be from any theoretical foundation.
In Our Models
This week our investment committee convened and approved three portfolio changes. One was an ETF swap in our Multi-Asset Income strategy and one was a slight tweak to our methodology of calculating dividends in our Target Excess Yield suite. There was, however, one portfolio change that triggered a larger portfolio rebalance.
Going forward, the Newfound U.S. Equity Long/Short portfolio will be known as the Newfound Dynamic Alternatives portfolio. The change in name accompanies the increased universe of potential holdings from which we will be selecting for what used to be a pure equity factor long/short sleeve.
This change follows a similar change from May 2014 when we introduced the PowerShares Multi-Strategy Alternative ETF “LALT” to the portfolio. LALT contains within it 5 strategies covering equity long/short, hedge fund conviction long/short, currency carry, forward rate bias, and volatility term structure premium. These holdings diversified our existing value, size, momentum, and anti-beta equity long/short holdings and helped increase liquidity.
The recently approved change will remove the value, size, and momentum long/short holdings – which had incredibly low secondary liquidity in the ETFs – and introduces a value & quality long/short, a merger arbitrage strategy, a hedge-fund replication strategy, and a managed futures strategy.
These new holdings, plus the existing anti-beta equity long/short and the multi-strategy alternative, create a diversified set of alternatives strategies that we believe will rely less on how individual factors perform and will have a greater probability of creating a positive total return year-over-year.