Index effect in action

Standard & Poor’s (S&P) has given traders a unique opportunity to see how a certain market phenomenon—the so-called “index effect”—plays out in real time.

After last Friday’s close, S&P announced it was adjusting the components to three of its stock indexes, with the addition of Palantir (PLTR), Dell Technologies (DELL), and Erie Indemnity (ERIE) to the S&P 500 (effective September 23) getting most of the attention. But those were just three of 40 stocks that S&P added or removed from the S&P 500, S&P MidCap 400, and S&P SmallCap 600, or shifted from one to the other:

Many of the stocks on the list showed evidence of getting an “index bump” (getting added to an index) or “index bust” (being dropped from one) on Monday.

The green rows highlight the stocks that were added to an index without having previously been in one, while the red rows are stocks that were dropped altogether. The remaining rows are stocks that were moved to a different benchmark, some to a larger-cap index (e.g., S&P 400 to S&P 500, or S&P 600 to S&P 400), others to a smaller-cap index (S&P 500 to S&P 400, S&P 500 to S&P 600, or S&P 400 to S&P 600). Here’s how Monday’s performance broke down between the different groups:

•New additions to an index (green): All 14 of these stocks rallied (6.8% average), and two (ADMA and PLTR) ended the day on the LiveAction scan for largest percentage gains.
•Dropped from an index (red): Nine of these 14 stocks closed lower (-2.4% average), with two (AMC and VREX) on the LiveAction scan for largest percentage losses.
•Moved to a smaller-cap index (yellow): Four of these 10 stocks closed lower.
•Moved to a larger-cap index (blue): Both stocks (ERIE and FN) closed lower on Monday, but by less than -1%.

Overall, these returns seem to support the presence of an index effect on Monday. The stocks that were being added to an index for the first time rallied, most of the stocks that were being dropped declined, and stocks that were being shifted from one index to another had more random performance. This “makes sense” because it reflects what has to happen behind the scenes: When a company is added to an index, all the funds tracking it need to buy its stock. The reverse is true when a company is dropped from an index. And if a stock is being removed from one index and added to another, both buying and selling may be taking place.

The key question for traders and investors is whether these events represent an opportunity—and if so, is the prudent trade to go with the initial move or fade it?

A few market realities bear on the answer. First, the funds don’t have to repeatedly buy stocks that are added to an index they track, they just need to do it once. So, even if an index bump occurs, it may disappear more quickly than traders assume. For example, “Index bump gets stumped” shows what happened to a stock earlier this year when it was added to the S&P 600.

Second, other factors can outweigh any potential index effect. For example, RILY was dropped from the S&P 600 but it still rallied strongly on Monday after announcing a series of strategic and financial initiatives. (It gave back roughly half the gain on Tuesday.) Also, the broad market’s strength or weakness on any given day may exaggerate or partically offset an individual stock’s move. With that in mind, let’s review Tuesday’s returns:

•New additions to an index: seven declined, seven rallied.
•Dropped from an index: 10 of 14 declined.
•Moved to a smaller-cap index: five of 10 declined.
•Moved to a larger-cap index: ERIE closed higher and FN closed lower.

Stocks that were dropped from indexes were more bearish on Tuesday than on Monday, but stocks that were added to indexes were also net bearish. ADMA Biologics (ADMA) fell into this group, gaining 13.5% on Monday and falling 5.9% on Tuesday:

If nothing else, these examples should give traders pause about the prospect of any individual index-effect move to sustain itself. Some may, others won’t. But traders who track these stocks in the coming days should develop some valuable insights about how these events play out in the real world.

Today’s numbers include (all times ET): mortgage applications (7 a.m.), Consumer Price Index (8:30 a.m.), Quarterly Services Survey (10 a.m.), EIA Petroleum Status Report (10:30 a.m.).

Today’s earnings include: Cracker Barrel (CBRL), Designer Brands (DBI).

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