I wouldn’t normally use this column to analyze the daily movements of any individual equity. As you all know, there are many reasons for a stock price to move day in and day out, and as long term investors, we don’t like to get too deep into those daily gyrations.
However, when a client asked me about the sudden upward move in the shares of a well-known company this week, I was actually able to give somewhat of a definitive answer. I thought it was an interesting market dynamic that would be worth discussing here.
Note: Before we go any further, please know this column is not meant to be a recommendation towards an investment in the company discussed. Individual stock investing includes risks. Please consult your financial advisor
The company who experienced a one day pop was Lululemon. Lululemon, if you aren’t familiar with the brand, is an athletic apparel company based on Vancouver, BC. The company is often credited with sparking the “ath-leisure” clothing category. On Monday of this week, Lululemon’s stock price rose over 10% and there was no company-specific news or earnings release. A client noticed the move and asked what happened.
While there can always be a few factors in play, one was clearly a key contributor. It was announced that Lululemon would be admitted mid-week into a popular market index , the S&P 500 – which we discussed in this column. A spot had opened up in the index as Activision Blizzard was removed upon the finalization of its acquisition by Microsoft.
Why would addition to an index cause an instant increase to a stock price? It can be best understood by revisiting a simple economic concept – supply and demand. There is a set amount of outstanding shares of Lululemon on any given day (barring any repurchases by management or added funding rounds) – so supply is inherently fixed. However, the addition to the index led to a sharp increase in demand for the shares. Supply steady, rising demand = higher price.
Why would demand increase just based on the addition to an index? If you refer to our article on the S&P 500 linked above, you’ll remember that it is one of the most popular indexes used to track/mimic returns of the broader US equity market. It’s estimated that there is $16 trillion pegged to its composition. When a stock is added to the index, the money managers or computer algorithms tracking the index need to buy shares of the company in order to stay “on track” with the index. The instant tick-up in demand upon announcement is either managers adding the name or traders anticipating they will.
This additional demand can clearly be seen in the trading volume. Lululemon has approximately 127 million shares outstanding and an average daily share trading volume of around 1.5 million shares. On Monday, over 11.4 million shares traded followed by 28 million on Tuesday. Clearly, there was a noticeable pick-up in demand for the shares, resulting in a higher share price.
An interesting look at how index composition can (and often times does) impact the prices of its constituents.
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