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OPINION

Playing Footsie

Playing Footsie
March 14, 2011
Playing Footsie

In fact, if you had followed this strategy from the beginning of the last equity bull market in March 2003 until the market peaked in June 2007, you would have made an average quarterly gain of 13.6 per cent on each of the 27 companies that dropped out of the FTSE 100 following the Quarterly Index Review. By comparison, the FTSE 100 only managed to rise by 5.3 per cent on average in these 13 quarters.

And after the stock market bottomed out in March 2009, this trading strategy worked brilliantly for the subsequent 12 months. In fact, the laggards dropping out of the FTSE 100 in March 2009 rose by 35.6 per cent in the following three months and the subsequent three month returns were: 19.4 per cent, -1.2 per cent and 20.7 per cent for the drop-outs from the June, September and December reviews in 2009. Admittedly, the strategy did not deliver a profit a year ago when I advised buying shares in Resolution, but a sharp general market correction, driven by the eurozone financial crisis, and technical selling when the life insurer announced a large acquisition and rights issue, partly explain the underperformance. And though you would have just about broken even by buying the dog shares in June and September last year, you would have been rewarded handsomely by buying shares in the only drop-out in the December Review, Cobham. Shares in the defence company have soared 15 per cent in the past 12 weeks against a 1 per cent decline for the index. So why does it work?

Reasons for phenomenon

There are several reasons why FTSE 100 laggards have a tendency to bounce back after their expulsion from the index. First, technical selling pressure in the run-up to their expulsion depresses valuations well below fair value as index-tracking funds, whose mandates dictate that they are only allowed to hold shares in FTSE 100 constituents, are obliged to sell shareholdings in companies being ejected from the index.

Second, the Quarterly Review is held on the second Wednesday of March, June, September and December with changes to the index implemented seven trading days later. The delay between the announcement of a company's ejection and the date the changes are implemented enables traders to profit from this technical selling pressure by fund managers. For example, some investors will short-sell shares around the time of this seven-day window with the aim of turning a profit by buying them back at a lower price at a later date, which exacerbates price falls.

Third, the fact that a company is being ejected from the FTSE 100 is due to a relatively poor share price performance which creates a negative momentum effect, whereby some traders will pairs-trade these underperformers against the FTSE 100, safe in the knowledge that forced selling by tracker funds could drive prices down even lower.

Academic studies

Academic studies also validate this strategy. In a paper 'Playing Footsie with the FTSE 100' published in 2006, professor Jay Dahya of City University of New York considered changes to the index over the period 1984 to 2003. Mr Dahya noted: "Deletions to the index are associated with a negative price response, which is fully reversed over a 120-day period after news of the removal from the index." He added: "The rebound in stock prices following exclusion from the FTSE 100 is also positively related with analysts' earnings upgrades (a feature of bull markets) and negatively related with a change in press coverage."

While in a paper 'The Impact of Changes to The FTSE 100 Index', The Financial Review, August 2007, Brian Mase of Brunel University found that: "Return reversal around index additions and deletions suggests that buying (selling) pressure moves prices temporarily away from equilibrium." It is this excessive selling pressure that drives down share prices below fair value and creates the conditions for a bounce back in the shares once the laggards are ejected.

Moreover, it’s not as if there aren’t good reasons why shares in Alliance Trust, African Barrick Gold and Bunzl - the three FTSE 100 companies exiting the index at close of trading on Friday 18 March - could enjoy a strong technical share price recovery in the coming weeks.

For instance, Alliance Trust's shares trade on a hefty 18 per cent discount to net asset value following a 6.7 per cent slide in the past month to their April 2010 high around 350p.

African Barrick is only rated on a 2011 prospective PE ratio of 8 following a 13 per cent slide since late February and the shares are sitting just above a strong support level of 500p, a point from which strong rallies have previously ensued. For good measure its 14-day relative-strength index (RSI) is heavily oversold.

The same is true of Bunzl's shares, which have retreated back to their November and December lows around 700p, a key support level. Reassuringly, its 14-day RSI is as low as it was back then so the set up is positive for a rally from an oversold level. So, if like me, you believe the underperformance of these FTSE laggards is set to reverse, then buying the shares at close of trading on Friday 18 March is the smart way to profit from the recovery.