19
selected by this committee. In fact, S&P wisely resisted adding a number of technology and internet
firms in the late 1999s into the index although they attained huge market values.
21
Cyclical Overvaluation of New Firms
Despite S&P’s restrained, there is pressure to add firms of high market value when there is a
vacancy in the index. Therefore, when investor demand for a particular sector is high, such as for the
oil service stocks in the 1978-80 energy bubble or the technology and telecommunications stocks in
the 1998-2000 bubble, these stocks become candidates for admission to the index. Their high price
relative to fundamentals leads to a downward bias to future returns.
22
For example, the underperformance of the updated energy sector is due primarily to the oil and gas
extractors, many of which were added during the energy boom of the early 1980s. In fact, 12 of the
13 energy stocks that were added during the 1980s, such Texas Oil and Gas, McDermott
International, Pennzoil, Rowan, Baker Hughes, Helmerich & Payne, underperformed the index.
The telecommunications sectors also experienced a boom that resulted in the addition of overpriced
stocks that dragged down the performance of the sector. This sector added virtually no new firms
from 1957 through the early 1990s. But in the late 1990s, new firms, such as WorldCom, Global
Crossing, and Qwest entered the index and subsequently underperformed the average by a large
margin. In June of 1999 WorldCom constituted over 16% of sector’s market value, but subsequently
lost 97.9% of its value by the time it was deleted from the index in May 2002. Qwest lost over 65%
of its value since it was admitted, while Global Crossing lost over 98% of its value before it was
deleted in October 2001.
The technology sector, despite a few very successful firms, has been hurt by firms that have been
added when the public’s demand for technology stocks is high. Thirty six of the 125 technology
firms that have been added to this sector since its founding occurred in 1999 and 2000, and two-
thirds of these have underperformed the sector’s return since their admittance. Firms admitted in
1999 underperformed the sector by 4% per year and those admitted in 2000 subsequently
underperformed the sector by 12% annually. Despite the huge success of firms such as Intel,
Microsoft, Cisco, and Dell, the drag from the addition of overpriced technology firms significantly
hurt the performance of this important sector.
Price Pressure from Indexing
Another reason for superior performance of the original firms relates to the overvaluation of new
firms caused by price pressure exerted on new stocks by indexers that must buy shares of the firms
added to this popular benchmark. Standard and Poor’s Corporation published a study in September
2000 that noted that from the announcement date to the effective date of admission in the S&P 500
21
During the internet boom, S&P only admitted AOL, in January 1999 and Yahoo in December, 1999.
22
Ritter, Jay, ’Hot Issue’ Market of 1980, Journal of Business, 1984 (vol. 57, no. 2), pp 215-240 documents a similar
phenomena in the poor performance of initial public offerings during hot issue markets.