It’s interesting to see how the removal of a company from an index is, counterintuitively, perhaps one of the better ways to anticipate future performance – unless it goes bankrupt, of course. For example, Sears was removed from the Dow in favor of Microsoft in 1999, but whereas one would have lost 39 percent over the last five years by investing in Microsoft, Sears stock is up 81 percent.
I haven’t completed my analyses of dropped vs added stocks yet, but it appears that stocks almost always experience their best run prior to being invited to join an index, which would appear to indicate that either the market makers are investing ahead of time and then cashing in by distributing shares to an unsuspecting public once the stock hits the index, or they’re making the same mistake that most people make in assuming that past performance is an indicator of future performance.
Since the stocks are already tradeable and the whole point of the exercise is to make the index look prettier – in other words, go up – I’m assuming the latter.
Interestingly enough, the eight stocks dropped from the NDX on December 10, 2004, have significantly outperformed the new additions. The former are up 15 percent on average, the latter are down 3 percent.
It’s too soon to tell and too close to call with the newcomers to the lower-beta Dow Jones industrial average, as the three new additions are up 3 percent in the first three months, while the three dropped are down one percent. But the results of the 1999 “rebalancing” are clearly in favor of those dropped: Sears, Goodyear and Chevron are up 44 percent since being dropped from the Dow 30, (Union Carbide was acquired by Dow in 2001), while 1999 inductees Microsoft, Intel, SBC Communications and Home Depot are down 36 percent since joining the index.
The Law of Unintended Consequences triumphs yet again….