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Why stocks need to rally in January -- or else

Stocks are starting the New Year in rough shape. For 2015, the Dow Jones Industrial Average lost 2.2 percent and the S&P 500 lost 0.7 percent.

Bespoke Investment Group notes that while the S&P 500 posted a modest loss, the average stock within the index was down 3.8 percent. The 50 largest stocks gained 1.5 percent while the 50 smallest stocks lost 11.9 percent. And the stocks that performed the worst in 2014 (think energy) lost another 28 percent in 2015.

Can the bulls turn things around in January, historically one of the best months of the year for stocks?

January has been the best month for the Nasdaq composite index since 1971. It's the fifth best month for the S&P 500 index and the sixth best for the Dow Jones industrials index since 1950. It typically marks the end of the best three-month span of the year for equities.

We need a repeat performance.

The first week of January marks the tail and of the "Santa Claus rally" that I discussed in a recent post, a period starting on December 24 and ending on January 5 which over the years has featured an average S&P 500 gain of 1.5 percent. When stocks fail to rally during this period, market underperformance or even bear markets tend to follow, according to Jeffery Hirsch of the Stock Trader's Almanac.

January also can provide signaling effects on what to expect for the rest of the year. Hirsch's "Early Warning System" looks at what stocks do during the first five days of the year and extrapolates that out into the rest of the year. In the last 16 presidential election years, 14 followed the direction of the first five days, he said.

Hirsch's father created the "January Barometer" back in 1972, which simply extrapolates January's performance on the full year. Since 1934, it has carried an 88 percent accuracy rate with only eight major errors in the past 65 years.

If stocks falter in the next few weeks, the weight of market history will suggest investors are in for a rough ride for the rest of 2016.

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