Sent: 05-03-2013 15:47:02
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S&P Indices Aggravate Share Price Cyclicality
Demand for individual stocks will depend on whether they are included in market indices. As S&P showed again in the past week, changing the weighting of cyclical stocks after their share prices have fallen encourages selling near the bottom of the market and buying near the top.
On 1 March, S&P Dow Jones Indices announced the quarterly rebalance of the S&P/ASX indices used as performance benchmarks for the Australian market. These are the indices such as the S&P/ASX 300 referred to on daily news bulletins and reported on financial market sites and business television programs. The indices are also the test of how a fund manager is performing.
The impact on fund manager decision making is especially important. As a stock enters the major indices such as the S&P/ASX300 and S&P/ASX200, it potentially attracts fresh buyers. Those managers or products attempting to replicate market outcomes will be drawn like moths to a light to the stocks newly included in the index. Fund managers in Australia and overseas also have more freedom to buy stocks in these indices than an otherwise identical stock that is not in one of the indices.
Active managers should have more flexibility to depart from an index. Even so, if the S&P/ASX 300, for example, is the benchmark against which they are to be judged, its constituents will be the starting point for portfolios. Managers will have to justify to trustees why their stock weightings are higher than or lower than the index weightings and their respective tracking errors.
The actual changes in the indices announced last week will take effect after the close of trading on 15 March 2013. Between the announcement of the changes and their implementation, stock price and volume volatility may be prone to increase as speculation about which stocks will enter or exit the indices gives way to certainty and the need to adjust portfolios.
One of the features of the latest round of index changes has been the disproportionately high impact on resource sector constituents.
Within the S&P/ASX 200, four stocks are to be removed and four new stocks added. All the stocks to be removed are miners. Only one of the added stocks - Horizon Oil - is from the resources sector.
Within the S&P/ASX 300, there are going to be 17 additions and 12 deletions. Of the additions, 13 are industrials and four have come from the resources universe. Among the 12 stocks to be removed from the index, eight are resources companies and four are industrial stocks.
Of the four industrials being pulled out, two have a resources flavour, in any event. Watpac has a resources connection through its civil engineering, construction and mining contract work. Ceramic Fuel Cells aims to convert natural gas to electricity.
The end result of the reweighting is effectively a recommendation from the index supplier that investors, including the largest superannuation portfolios in the country, should reduce their exposures to the resources sector and up their weighting in industrial stocks.
This is not a recommendation designed to make investors money. It is purely a reflection of the most recent share price performance. Over the last 12 months, for example, the small industrials share price index rose by 14% while the small resources segment of the market declined by 35%.
The construction of the S&P indices, by concentrating on market capitalisation as the qualification for entries and exits, reinforces the cyclicality of resource stock equity prices.
As long as interest rates are low and the macroeconomic environment remains uncertain, some strategists will say, the strongest performing parts of the equity market will remain industrial stocks with relatively high yields.
The same set of macroeconomic conditions will work against the resources sector especially the smaller resource stocks most highly leveraged to an improvement in global growth.
Over the last 12 months, the largest resources stocks in the sector (i.e. those in the S&P/ASX 100) have outperformed the remaining resources stocks in the S&P/ASX 300 by 29 percentage points. Such an extreme difference in performance is near a 20 year record. To that extent, stock prices have been adjusting to the macroeconomic environment.
The flow of funds into the sector will be further curtailed by the latest index restructuring and any further changes in response to resources sector underperformance.
Of course, if the resources sector retains its historical cyclical characteristics, there will be a point when the share price momentum changes and the index re-positioning will need reversing. As the index constructors react to a turn in the underlying cycle, they will promote a dramatic acceleration in fund flows.
By repeatedly adding mining and oil and gas companies to the headline indices through the subsequent upswing in the cycle, the index manufacturers will prolong positive share price momentum even as more value oriented investors are pulling back their own allocations.
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