Price and Volume Effects Associated with Changes in the S&P 500 List: New Evidence for the Existence of Price Pressures

Attempts to identify price pressures caused by large transactions may be inconclusive if the transactions convey new information to the market. This problem is addressed in an examination of prices and volume surrounding changes in the composition of the S&P 500. Since these changes cause some investors to adjust their holdings of the affected securities and since it is unlikely that the changes convey information about the future prospects of these securities, they provide an excellent opportunity to study price pressures. The results are consistent with the price-pressure hypothesis: immediately after an addition is announced, prices increase by more than 3 percent. This increase is nearly fully reversed after 2 weeks. THE EFFICIENT MARKET HYPOTHESIS (EMH) predicts that security prices reflect all publicly available information. Therefore, one corollary of the EMH is that "you can sell (or buy) large blocks of stock at close to the market price as long as you can convince other investors that you have no private information."1 This statement assumes that securities are near perfect substitutes for each other. If so, the excess demand for a single security will be very elastic, and the sale or purchase of a large number of shares will have no impact on price. In contrast to the EMH, Scholes [8], Kraus and Stoll [5], Hess and Frost [4], and others propose two hypotheses which predict that a large stock sale (purchase) will cause the price to decrease (increase) even if no new information is associated with the transaction. The imperfect substitutes hypothesis (ISH), also known as the distribution effect hypothesis, assumes that securities are not close substitutes for each other, and hence, that long-term demand is less than perfectly elastic. Under this hypothesis, equilibrium prices change when demand curves shift to eliminate excess demand. Price reversals are not expected because the new price reflects a new equilibrium distribution of security holders. The price-pressure hypothesis (PPH) assumes that investors who accommodate demand shifts must be compensated for the transaction costs and portfolio risks that they bear when they agree to immediately buy or sell securities which they otherwise would not trade. These passive suppliers of liquidity are attracted by immediate price drops (rises) associated with large sales (purchases). They are compensated for their liquidity service when prices rise (drop) to their fullinformation levels. The PPH, like the EMH, assumes that long-run demand is