Standard & Poor's Timing Strikes Some as Curious

It's getting harder and harder to convince conspiracy theorists that varied forces aren't trying to boost the stock market, however futile those efforts appear in light of Wednesday's selloff.

As has been widely reported, Standard & Poor's Tuesday night announced it will remove seven (eek!) foreign companies from the S&P 500 and replace them with firms domiciled in the good old U.S. of A.

Predictably, shares of the seven companies coming out, Royal Dutch Petroleum (RD Quote), Unilever (UN Quote), Nortel Networks (NT Quote), Alcan (AL Quote). Barrick Gold (ABX Quote), Placer Dome (PDG Quote), and Inco (N Quote) were lately down between 3.3% and 14.2%.

Conversely, the seven names going in, United Parcel Service (UPS Quote), Goldman Sachs (GS Quote), Prudential Financial (PRU Quote), eBay (EBAY Quote), Principal Financial Group (PFG Quote), Electronic Arts (ERTS Quote), and SunGard Data Systems (SDS Quote) were almost uniformly up, fluctuating between 0.4% down and 5.9% higher.

The changes were made to make the S&P 500 "a better reflection of the large-cap segment of the U.S. equities market," S&P's index committee chairman David Blitzer said in a statement Tuesday night.

Blitzer, who didn't return calls seeking additional comment Wednesday, added in the statement that the changes were made now because "there is an unusually large supply of eligible" U.S.-based firms available for inclusion and because turnover in the index is its lowest since the early 1990s.

High turnover creates higher trading costs for index funds, which have roughly $1 trillion benchmarked to the S&P 500. So S&P is saying "we can afford more turnover right now," said Brad Pope, head of U.S. equity index product strategy at Barclays Global Investors, which had nearly $379 million indexed to U.S. equities as of March 31. "OK, fine ... but low turnover is always good."

Cleaning House

Nevertheless, Pope saw the changes as an opportunity for S&P to "clean up the entire S&P index family" -- many of the names being deleted from the S&P 500 are components of other S&P indices -- and that "they have an alignment of the stars to accomplish a goal and do it in a timely fashion."

OK, fine, but other market participants were less forgiving, noting the changes came the day the index fell yet again below its Sept. 21 closing low -- as of 2:30 p.m. EDT, the S&P 500 was down 3% to 923.82 -- and following a 13.7% decline in the first half of 2002.

Cynics observed that the companies being deleted -- some have been index components for over 60 years -- have roughly $30 billion larger combined market cap then those coming in. Given that approximately 10% of the S&P 500 is indexed, that means index funds will have about $3 billion left over to be reinvested in the other 493 companies.

The market cap on the day the changes take effect, at the close on July 19 -- which happens to be options expiration -- matters most. But as S&P's Blitzer told The New York Times, "When the dust settles, the index funds will buy a little bit more of the other 493" stocks in the index.

Taking the conspiracy theory a step further -- into its darkest realm -- goldbugs noted Barrick and Placer Dome are two of the largest components of the Philadelphia Stock Exchange Gold & Silver Index, which was recently down 1.4% vs. a 0.4% dip in the price of the metal.

Other Facts and Figures

However you slice it -- and whatever you think of the motivation -- the fact is that S&P 500 index changes are a big deal and this is the biggest change to the index since 1983, when seven Baby Bells were added.

An S&P study released in September 2000 showed stocks being added to the S&P 500 gained an average of 8.5% between the announcement and the implementation date, and gave back about half those gains in the ensuing year. However, a January 2002 study by Goldman Sachs suggested that this so-called index effect is shrinking and that a much smaller gain, if any, can be expected for additions.

"The No. 1 factor that determines performance of a company being added to the index is the three-month realized volatility" of the stock, according to Diane Garnick, global equity strategist at State Street Global Advisors, the largest asset manager in the U.S. with total of price pattern to expect between now and next Friday."

Given that eBay has the highest volatility of the stocks being added to the S&P 500, it should have the "strongest performance between now and next Friday's close," said Garnick.

Another factor in the performance of S&P 500 additions is whether they come from outside S&P's family of indices or migrate from the S&P MidCap 400, as is the case with Electronic Arts and SunGard Data. (Pier 1 Imports (PIR Quote) and PetsMart (PETM Quote) will replace those two in the MidCap 400.)

Since January 2001, stocks from outside S&P's indices have outperformed the S&P 500 by an average of 5% the day following S&P's announcement and by an additional 3% from the time of announcement through the effective date -- in this case July 9 to July 19 -- according to Merrill Lynch. But a "significant portion" of the initial outperformance occurred in a gap-up at the opening of trading and is thus difficult to capture.

Meanwhile, companies coming from the S&P 400 into the S&P 500 generally outperformed by 3% the day after changes were announced but underperformed by 4% from the time of announcement through the effective date, Merrill noted.

Ten days after inclusion, additions from outside S&P's indices back 5% of their outperformance, while those that came from the S&P 400 outperformed the S&P 500 by 1%.

On the other hand, there's a potential deleterious effect of being added to the S&P 500 if index funds suffer redemptions and are thus forced to sell index components. Such selling might also generate capital gains tax realization and distributions for index holders who don't redeem.

"If dollars start to flow out of the index and move back into active strategies" or out of the market entirely, "inclusion [in the S&P 500] is going to be a negative event," said State Street's Garnick, known to friends as a single, gorgeous math nerd. (I added the flattering modifiers on a dare from Garnick, who regretted describing herself as "math nerd" when it turned up in a 1999 column.)