By Steve Sosnick, Chief Strategist at Interactive Brokers
Frequent readers know that I have frequently referred to Tesla (TSLA) as a “faith-based” stock because of its holders’ near-religious zeal for the company, its products, and its shares. The faithful have been rewarded throughout the company’s existence, with the stock trading at astounding valuations.
The believers were reaffirmed once again last week, when S&P Dow Jones Indices announced that Tesla will be joining the S&P 500 Index (SPX) on December 21st as part of the index’s quarterly rebalancing. To steal a term from baseball terminology, it will be traded for a player to be named later – the company it is replacing has not yet been announced.
This is big news, and it is quite understandable that TSLA shares are trading about 13% higher. Inclusion into SPX requires that the passive managers buy the shares in order for their holdings to properly replicate the index. For a company the size of TSLA, that purchase requirement is staggering. After last week’s rise, TSLA would enter the index as the 8th largest company in the index – after Berkshire Hathaway (BRK.B) and ahead of Johnson & Johnson (JNJ).
That would represent about 1.4% of the weight of SPX. When one considers that there is over $12 trillion indexed to SPX, it implies that indexers will require about $170 billion worth of TSLA shares. That is a huge amount, but remember that TSLA has added over $40 billion in market capitalization on today’s move alone.
Remember that rebalancing means that something must be sold in order to pay for something that is bought. That is why the S&P index committee typically tries to find companies of similar sizes to replace one another when one is removed for a takeover or similar event. If company A is being purchased for cash, indexers can simply use that case to buy shares of company B if it is similarly sized. Yet there are simply no companies slated to leave the index that are as huge as TSLA.
That is why the index committee has given the markets over a month’s notice to prepare for the news, and made the rare announcement that they would consider doing the addition as part of a two-step process. This will be a very disruptive event for index investors, and potentially the markets as a whole. The $170 billion for TSLA shares will need to come from somewhere, and that means that markets will need to accommodate that amount of selling in the other 499 shares in the index.
So far I have seen many news stories fretting about where the indexers’ TSLA shares will come from, considering true believers’ reluctance to sell. There are two obvious sources that one must consider – the company itself and Elon Musk. One would have to expect that index addition would represent a buying climax, and thus a terrific opportunity for either the company or its largest holder to raise cash by selling into strength. This is hardly an unprecedented idea. I found the example of Mosaic (MOS), which had a holder sell about 30 million shares into that stock’s index addition in 2011. That proved to be an excellent sale. I know there are other instances, but as of now I have not been able to find them.
The ancillary effects of this announcement are numerous. Others to consider are:
- What will this do to VIX? Adding another volatile tech-oriented stock to the index should increase SPX volatility.
- Will this close the gap between VXN and VIX? VXN is based on the NASDAQ 100 Index (NDX), and TSLA is the largest stock in NDX that is not currently in SPX
- Will this put a lid on the rotation trade? For the next month, SPX indexers (or those front-running the addition) will need to accumulate shares in TSLA and sell corresponding dollar amounts of the other 499 stocks. That means we will see demand for that specific growth stock and pressure on the multitude of value stocks in SPX.
- What will be the next catalyst for TSLA? Addition to SPX was the single largest rationale for the non-believers to own TSLA shares. This company has always had a “next great thing”. What could replace SPX addition in that regard?
Photo Credit: Chris Hunkeler via Flickr Creative Commons
This article first appeared on Traders’ Insight
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