Did S&P Just Guarantee a Holiday Rally For Facebook's Stock?

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

Stocks are dropping this morning, with the S&P 500 and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) down 0.25% and 0.47%, respectively, at 10:15 a.m. EST. I'm surprised the market isn't showing a more enthusiastic reaction to the prospect of a federal budget agreement that looks headed for a House vote today and a Senate vote next week. The agreement would avert another government shutdown on Jan. 15.

Standard and Poor's U.S. Index Committee is consecrating Facebook's (NASDAQ: FB  ) return from ignominy, after a botched May 2012 initial public offering, by adding the stock to the widely followed S&P 500 index. The addition will take place after the close of trading on Dec. 20.

The announcement was made after the close of trading yesterday; this morning, Facebook shares are up 3.2% at 10;15 a.m. EST. Why the pop? In economic terms, the addition has no impact on Facebook's intrinsic value; however, the price action is likely being prompted by traders positioning themselves ahead of the forced buying by index funds that need to own the shares in order to replicate the S&P 500. Consider that a whopping $1.6 trillion in assets are indexed to the S&P 500; the two largest index exchange-traded funds (the SPDR S&P 500 ETF and the Vanguard S&P 500 ETF) alone weigh in at more than $300 billion.

The buying by index funds will be considerable. By my calculations, if Facebook had been added to the index after yesterday's market close, it would have a weight of 0.51%, roughly equivalent to that of ConocoPhillips or Bristol-Myers Squibb. As such, index funds would need to buy an aggregate $8 billion worth of Facebook shares, or slightly more than 10% of the float (freely tradeable shares) to match the index!

That's the result of Facebook's unusual combination of two characteristics: a megacap valuation and a low float. As of yesterday's close, Facebook would have been the No. 31 company in the index by market value, at $121.2 billion (just behind technology bellwether Intel). As far as I can tell, it's the largest addition to the S&P 500 since Berkshire Hathaway in February 2010; the day following that announcement, Berkshire's B shares gained 4.9%. However, more than 80% of the companies in the S&P 500 have a float of 90% or higher; Facebook's, meanwhile, is just two-thirds.

Index funds are valuation-insensitive -- their mandate is to replicate the index, nothing more -- but stock pickers shouldn't be. At 48 times next 12 months' earnings-per-share estimate, Facebook shares already look richly valued; investors ought to be mindful of that before they consider buying any of them for their Christmas stocking.

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