Wednesday, January 7, 2015

The Bullish "Year 5" Set Up Is Missing A Key Ingredient

Patterns in the stock market primarily persist for a reason.

For example, downtrends are frequently reversed on Tuesdays. Why? Spooked investors may not want to hold risk over the weekend, so they sell on Friday. That weakness can persist through Monday. By Tuesday, stocks are relatively oversold and tend to rise.

Another example is the tendency for stocks to rise in the last 3 weeks of the year as managers chase performance or dress up their portfolios for year end statements to investors.

Which brings us to the tendency for stocks to rise in years ending with the number 5. This is 2015, so this matters. In the past 130 years, the Dow has risen an average of 29% in years ending with the number 5. Since 1900, years ending in 5 have been up 10 of 11 times.

There must be a reason why this has worked so well and so consistently. Indeed there is.

In 6 of the 10 times that stocks have been higher in years ending in 5, the market was down in at least one of the two prior years (red boxes). In other words, most of the time investors are coming into years ending in 5 having been recently shaken out.

In 2 more cases, the prior year was flat (blue boxes). Stocks rose very marginally in 1934 and 1994; on an inflation adjusted basis, 1994 was actually down and 1934 was up a scant 1.5%. That might not seem significant but flat years also shake out investors. The Investors Intelligence bull/bear ratio was just 0.7x at the end of 1994; this means that more investors were bearish than bullish. That is quite rare. In comparison, that ratio now stands 3.7x, meaning there are nearly 4 times as many bulls as bears.

Down or flat years explain 80% of the gains that occur in years ending in the number 5. There were just two cases where stocks were up strongly leading into year 5: the booming 1940s and 1960s (green boxes).  That's hardly a ringing endorsement for a strategy of going long because 2015 ends in a number 5.

2015 is a unique set up. The Dow has been up 6 years in a row. The only other time this has happened was during the booming 1990s. These streaks usually end at 5 years or less. Neither 1945 nor 1965 had this set up: stocks had been down 3 of the 6 years before 1945 and 2 of 6 years prior to 1965.

None of this is to say that 2015 won't be a good year for stocks, or that the indices must fall. But the set up that has been crucial to years ending in the number 5 being so bullish is missing. Without that, there is no reason to believe that 2015 has to go higher just because it ends in a 5.

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