The January crystal ball

Ali Velshi is CNN's chief business correspondent and host of Your $$$$$, CNN's weekend business roundtable.

It’s a widely-held belief in the financial world that the month of January is a good predictor of how the market will do in a given year. So, as the theory goes, if January brings significant gains, then it’s a smart idea to invest heavily, because stocks should end the year high. Some superstitious stock savants take the myth even one step further and foretell the markets’ fortunes from January’s first five days alone.

The funny thing is there is absolutely no scientific or mathematical reasoning behind the so-called “January Barometer.” There’s no logical explanation why a bullish first five days of January should keep a bear in its cave for the next 360. The theory was created by Yale Hirsch, the editor-at-large of the Stock Trader’s Almanac, in 1972, and has captured the financial sector’s imagination ever since. And without fail, each year right around mid-December, the whisperings on the floor of the NYSE begin again. So what is it that keeps the myth alive? Are brokers just chasing financial unicorns?

Let’s take a look at some of the facts and you can be the judge:

1. According to the Stock Trader’s Almanac, since 1950 the January Barometer has made only five major errors about the S&P 500. That gives the indicator the almost frightening accuracy rate of 91.4%! And even those five errors are easily explainable by political or social events that were happening in those years like significant rate cuts or major military actions abroad.

2. January is packed with major events that affect markets worldwide. The only justification for the January Barometer is that so many things happen in January, particularly the inauguration of newly elected officials, the State of the Union, and the calculation of the U.S. annual budget.

3. According to the Stock Trader’s Almanac, out of the last 36 times the markets closed higher in the first five days of January, we saw year-end gains 31 times. That’s another highly impressive accuracy rate of 86%. 
 
It’s hard to argue with some of those statistics, though keep in mind the financial world is one in which prophesies can easily be self-fulfilling. If traders and investors believe the year will follow the first five days of January, then they can make it so. After all, as I’ve written before, the markets run on confidence and sentiment as much as they do on rates and stats. Heck if the January Barometer holds up, it would be a very good thing for the economy this year. On the first day of trading in 2009, the Dow broke 9,000 and gained nearly 3%, a welcome relief for investors.

Still, I don’t condone investing based on the inexact science of the January Barometer. As I explore in my new book "Gimme My Money Back"  good investing relies on knowing the rules of the game and investing intelligently, not judging a year’s worth of investment on five market days. That means diversifying your portfolio to lower your risk and thinking long-term. So don’t be swayed if everyone around you is reading the January tea-leaves. Maybe consider investing in Lipton.

Ali Velshi is CNN’s chief business correspondent and author of the new book “Gimme My Money Back: Your Guide to Beating the Financial Crisis,” published by Sterling & Ross. Read excerpts from the book.