Electric vehicle maker Tesla is poised to enter the S&P 500 in what will be the
largest rebalancing in the history of that index.
The new index with Tesla in it begins trading on Monday, but
all the trading action happens at the close on Friday.
The trading volume will be so heavy, some are concerned it
could result in fireworks at the close.
S&P estimates that approximately 129.9 million shares of
Tesla will need to be purchased to add to the S&P 500. At the current
market price of $655, indexers would need to buy $85.2 billion in Tesla stock
at the close on Friday. However, there are billions more that will need to be
bought by “closet indexers” that do not officially pay S&P, but nonetheless
track the index. No one knows how much these “closet indexers” will buy, but it
could be 50%-100% above the “official” $85.2 billion estimate.
Even at the lower estimate, that means that more than $85
billion in the rest of the S&P 500 will need to be sold. This will be by
far the largest rebalancing in the history of the S&P. The prior record of
$50.8 billion was in September 2018.
“This will be one of the largest trading days in a long
time,” said Harry Whitton of market maker Old Mission, noting that the large
dollar amount involved could make it the largest trading day in history.
How Tesla will change the S&P 500
The sheer size of Tesla will have a significant impact on
the S&P 500, which is weighted by the free-float market capitalization of
each company.
Here’s how Tesla will change the S&P 500:
- Ranking: 7th largest
- Weighting: 1.52%
- 2021 P/E ratio: from a (pricey) 22.3 to a (even
pricier) 22.6
Source: S&P Dow Jones Indices
Like all mega-cap stocks, it will not take much of a move in
Tesla’s price to move the S&P 500:
For every $11.11 Tesla moves, the S&P 500 will move 1 point.
Index rebalancings: Big affairs now
Index rebalancing has become important because so much money
is now tied to these indexes through “passive” investing, which merely seeks to
mimic the behavior of the indexes.
Rebalancings usually involve changes in the weighting of the
companies listed in the indexes, but they can also involve additions or
deletions to the indexes, which is the case with Tesla. Mutual funds, ETFs, and
others that seek to mimic the behavior of the index must then buy or sell the
stocks in proportion to their weightings in the indexes.
What could go wrong?
The addition of Tesla into the S&P would itself be an
enormous trading event, but it is also happening when the S&P itself is
rebalancing all of the existing constituents.
It’s also occurring on what is known as a quadruple
witching, the quarterly expiration of index futures and options, and individual
stock futures and options.
“Two unprecedented phenomena will be converging,” Steve
Sosnick, chief options strategist at Interactive Brokers, wrote in a recent
note. “The index has never added such an immensely large stock at the same time
that options volumes and open interest are at record highs.”
Sosnick is concerned that the combination of the Tesla
addition, the quadruple witching, and the rebalancing in the rest of the
S&P 500 could result in very high imbalances in demand for stock that could
cause price dislocations. “There is a potential for massive market on close
imbalances because this is the biggest stock entry ever. There is an awful lot
of money that will be sloshing around at that time,” he said.
“Because this is such an event, we could be in for a much
more volatile market on close than people are used to, particularly with so
many retail traders involved in stock options that could swing in or out of the
money,” Sosnick added.
Others are concerned that the sheer volume of trading could
cause glitches, especially since most of it will be concentrated in the few
minutes toward the close.
The Nasdaq, which is the exchange where Tesla is listed,
recently put out a statement saying it was ready: “As Nasdaq and the securities
industry prepare for the upcoming quadruple witching and S&P 500 rebalance,
Nasdaq is highly confident that its systems will provide the reliability and
capacity required to ensure a smooth, successful rebalance.”
S&P 500 owners: Buying Tesla high
The addition of Tesla to the S&P highlights a major
problem for passive investors: They often buy stocks at high prices, and in the
case of Tesla, which is up 600% this year, at stupendously high prices.
Indexers often claim that the addition or deletion of stocks
to indexes do not change prices. While prices do not usually change drastically
between the price at 3:59 p.m. ET on the day of an addition or deletion and the
4 p.m. final price, prices can and do change significantly in the runup to
index changes.
On Nov. 16, S&P Dow Jones Indices announced that Tesla
would join the S&P 500 Index on Dec. 21. However, the stock had been
running up for months. Some of this was likely due to Tesla’s strong
fundamentals, some due to retail traders infatuated with Tesla.
But much of the runup was also likely due to speculation
Tesla would soon be added to the S&P, as Rob Arnott, Vitali Kalesnik and
Lillian Wu from Research Affiliates noted in a recent report:
“From the beginning of 2020 to the announcement date,
Tesla’s share price rose 400% from $83.67 to $408.09. Most of that runup
occurred after the media began speculating in March about Tesla’s likely addition
to the index. From the announcement date through December 7, Tesla’s share
price rose another 49% to $608.32.”
“That decision to include Tesla in the S&P in Nov. 16
created $200 billion in worth for Tesla shareholders,” Sosnick said.
Tesla’s price rise is exceptional, but Arnott and his
associates found that stocks do indeed rise going into the S&P and fall
when coming out. In a 2018 study of stocks that had gone into and out of the
S&P 500 from 1987 to 2017, Arnott found that the average mega-cap stock
(ranking in the top 100 or higher by market capitalization) outperformed the
S&P 500 by 127% in the 12 months prior to the close of the rebalancing day.
The average deletion loses 31% over the same time span.
Tesla: What happens next?
Not surprisingly, the pattern reverses after the addition
and deletion: The added stocks tend to underperform, the deleted stocks tend to
outperform. Arnott found that the average entry rises an additional 1% relative
to the market on the day after joined the index, then loses about 2% relative
to the market over the following year. The average deletion drops 1% more the
day after its removal from the index, then beats the market by an average of
20% over the next year.
What does all this mean? “The S&P 500 is designed to buy
high and sell low,” Arnott concluded.
Tesla’s size raises another point of concern: Typically,
only two to three of the top 10 stocks ranked by global market-cap remain in
that list 10 years later.
Arnott concluded that the weight of history is working
against a similar massive rise in Tesla’s stock in 2021: “Given all the
classical signs of a bubble in Tesla’s stock, and the evidence of 31 years of
S&P additions and deletions, December 21-22 likely marks the beginning of a
reversal in Tesla’s share price.”
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