Market Superstitions

Investing in the stock market requires a person to take a view on the future. Because we are investing for growth, we want to buy where we believe prices will rise. There are two ways of looking at this problem: either looking backward and buying where prices have recently fallen or remained steady, or looking forward and buying where prices are expected to rise. It’s a fairly simple matter to look backward and find out where prices appear low in relation to the past. This is usually considered to be the basis for a “value” style of investing. It’s more difficult to look forward and divine where prices appear low in relation to their future. This is more like the “growth” style of investing.

The future is opaque. While we can make predictions such as the probable result of rising affluence in hugely populous developing nations, the timing and the actual results are impossible to predict. Although the past doesn’t repeat itself, it often rhymes, giving people reason to rely on past experience when making decisions about the future. When trying to determine whether the stock market appears over-valued or under-valued, I can either look backward and determine the apparent value in relation to the recent past, or I can look to accumulated market experience. While the latter approach makes sense, it could be classified as superstition.

Superstitions are widely held beliefs about intractable realities. It is usually impossible to collect evidence to prove or disprove popular superstitions, such as the seven years of “bad luck” brought by breaking a mirror. Perhaps when mirrors were more costly and annual income was lower, there would be a negative financial impact with seven years’ worth of repercussions. For our purposes, however, let’s consider some commonly held beliefs about stock market performance.

I will briefly review three examples of stock market beliefs that may have some ability to detect future conditions. First, the January effect suggests that the performance of the stock market over the course of the year can be predicted by the performance of the market over the first five days or over the entire month of January. This factor has been correct a little over half the time. A notable failure was the conflicting signals given in 2007 and 2009. Second, there is a market dictum that states: “sell in May and go away.” This implies that stock performance is strongest over the course of November to May and weakest over the months of June to October. This has been true more often than not over the last three centuries. When the markets varied from this pattern, however, it was for a period of over 20 years (pre-1920 to 1950).

The last example is technical analysis. Divining patterns in charts, especially if they show only the result of random movements is of questionable value. At best, the charts may show the result of human behavior, which can be expected to follow a familiar pattern. However, when the pattern may develop at varying magnitudes and speeds, I remain extremely skeptical that there chart shapes, even if they do repeat themselves, can be effectively recognized ahead of time, allowing anyone to accurately predict future movements. I am unable to find a study which shows the level of effectiveness of this type of prediction.

Rational decisions are made by considering all known values, not by trying to predict the future. Any endeavor that relies on divining what may happen will tend toward superstition. Beliefs about stock market behavior in the future, either popularly-held or academically researched, hold many similarities with superstition. While predictions of future performance are interesting, they should not be used as a basis for investing. This includes, of course, my weekly stock market outlook, which I produce in an order to gauge what is happen, not predict what will happen.