This Strategy Delivers a +9.4% Payoff in a Week -- Again and Again

Amy Calistri's picture

Thursday, October 8, 2009 - 1:47pm

by Amy Calistri

The stock market may seem chaotic and unpredictable -- but there is some order, if you know where to look.

Some things, history tells us, tend to repeat.

One such instance happens every time the S&P 500 Index drops a stock with a low market capitalization to add a stock with a higher one.

The S&P 500 Index is the performance benchmark for U.S. equities. It’s comprised of 500 large U.S. companies that represent the many industries and sectors that make up our economy. Although the makeup of the index is fairly stable, Standard & Poor's does make changes from time to time. When it does, investors can make a quick and profitable trade.

The Selling Pressure
Hundreds of funds track the S&P 500. Some are large, like the Vanguard 500 Index Investor (VFINX), which has more than $45 billion in assets. When Standard and Poor's announces that a stock is going to be dropped from the S&P 500, each of those funds must sell the stock, which puts enormous downward pressure on the stock's price.

In fact, the 11 stocks that got bumped in the past year lost an average of -15.1% when they were dropped from the S&P 500 Index. Those losses occurred in just a matter of days – between the day Standard and Poor's made the announcement and the day they were dropped.

The +9.4% Recovery
But there’s a catch -- a profitable one. The losses were only temporary. Within a week, the 11 stocks had bounced back. The average gain was +9.4%.

So if you bought each stock the day it was dropped from the S&P 500 and held it for just one week, you would be up an average of +9.4%. And you could have pulled off that trade not once but 11 times in the past year.

It seems almost incredible. Could it really be that simple?

I wondered if these abnormally large returns were always this good. After all, 11 isn't a huge sample. So I went to the source and confirmed this strategy had been tested with an even larger sample size – with the same profitable results.

Standard and Poor's performed their own analysis on the price impact of S&P 500 Index deletions, using data from 53 deletions between 1998 and 2002. They determined that the average price gain on a stock was +10.0% in the ten days following its deletion from the index – with most of that coming in the first six days.

Who Will Be Next?
Standard and Poor's announces each change to the S&P 500 in advance, giving fund managers and investors ample time to make this trade. But investors might also want to keep an eye on the S&P 500 companies with the lowest market capitalizations. When a new company is added to the index, the corresponding deletion will come from the bottom.

Right now, the stocks with the three lowest market caps on the S&P 500 are:

The New York Times (NYSE: NYT), $1.16 billion
Eastman Kodak (NYSE: EK), $1.21 billion
Convergys Corporation (NYSE: CVG), $1.28 billion

So, keep your eyes open for the next +9.4% opportunity. I am.

Amy Calistri does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.