The markets got off to a surprisingly bad start in 2005. Last month’s 5% drubbing of the Nasdaq Composite was the worst January return since 1990, and the second worst in the history of the index. The S&P 500 and Dow Jones index didn’t fare much better.
January is usually one of the best months of the year to own stocks. Typically, savvy investors spend the bulk of December in tax-loss selling mode, and re-enter positions in January, resulting in an abnormally positive return for the first month of the year. The effect is intensified by those reluctant to purchase mutual funds in December because of the tendency of many funds to realize capital gains late in the year.
There are a number of reasons why the so-called January Effect failed to make an appearance in 2005. First off, there weren’t many market sectors that showed losses last year, which put a cap on the amount of tax loss selling in December. Second, the increasing popularity of exchange traded funds–the bulk of which realized no capital gains in 2004–allowed investors to establish their positions before the start of the New Year. These two factors alone significantly muted the amount of buying pressure during January.