Penny Stocks and Index Bias

The SEC defines a penny stock as one in a small and illiquid company that trades for less than $5 per share. Note that this is not a stock who's price is less than $1, it is one who's price is less than $5 (with other conditions). Penny shares have typically been associated with disreputable or highly speculative corporations that the SEC felt it needed to have special rules to protect ordinary investors from.

Today, a large number of very prominent companies trade below $5, and this is exposing some biases and flaws in processes that we have previously taken for granted.

The NYSE has suspended it's rule that all shares must trade above $1 or face mandatory delisting; the market capitalization of a substantial number of Dow Jones Industrial Average constituents have declined dramatically over the past months; some suggest that many S&P 500 Index constituents would no longer be selected to be included at this stage (the S&P index construction methodology is outlined here).

We need to remember, when examining the performance during this current financial crisis (per articulum) of indices composed before the crisis (pro articulum), that these indices are not updated frequently and are composed using arbitary rules that are not scale free.

For example, Standards and Poors currently requires that a company have a market capitalization of at least $3 Billion to be included in the index — Citigroup's is currently just $5.6B; General Motor's is just $1.1B; and both are index constituents.

Of course, this problem occurs because the selection is not done in a scale free fashion. Instead of starting with all domestic companies who exceed this arbitary threshold, they should rank the capitalization of all domestic companies and then use those ranked 1–500 for the index. That is a scale free method that is not purturbed by a sudden downdraught in the market.

Another bias in the indices is that people (meaning both the users and composers) don't like the index constituents to change all the time — yet, any grouping of items by a random number relative to a threshold will create a jitter in the membership among those close to the threshold. This is impossible to remove for any criterion that has a "hard" cutoff — although it can be damped by appropriate filtering techniques. The dislike of this phenomenon causes members to be kept in (or out) of the index for too long as the index committee tries to decide whether the fluctuation that carrier a single stock over the barrier will persist or not.