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 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 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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The article Did S&P Just Guarantee a Holiday Rally For Facebook's Stock? originally appeared on Fool.com.

Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned; you can follow him on Twitter @longrunreturns. The Motley Fool recommends Facebook. The Motley Fool owns shares of Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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