Tesla CEO Elon Musk speaks at an opening ceremony for Tesla China-made Model Y program in Shanghai on Jan. 7.
Aly Song | Reuters
Most investors can relate to the dilemma faced by the S&P Dow Jones Indices committee as it bypassed Tesla for inclusion in the S&P 500 last week.
Tesla had more than quadrupled this year, racing above a $450 billion market value to surpass all but a dozen S&P 500 stocks in size and consuming far more than its share of the market’s oxygen.
The committee, like investors everywhere, had to decide whether to defer to the market’s stampede into a select handful of stocks viewed as the owners of tomorrow’s digital economy or wait to see if the fever breaks to make a more considered call on whether they merit the hype.
The decision also highlights the ways a new jolt of aggressive trading by retail players and trend-chasing institutions tests today’s market structure and the vehicles used to access equity markets.
The S&P 500 is built to reflect the largest U.S. companies, and this would be the largest ever outside the index, its urgent investors implicitly demanding entry.
Yet the gains in Tesla were so extreme, the buying so fevered, the share-price action so disorderly, it would mean forcing the index funds wielding several trillion dollars in assets to grab for the hottest of hot-potato stocks.
Meantime, Tesla’s four-quarter streak of positive earnings – a prerequisite for S&P 500 induction – was arguably tenuous and perhaps a bit forced. Its sale of pollution credits accounts for its margin of profitability, aided by curtailed capital spending.
While its index inclusion came to be seen as a forgone conclusion – and, ultimately, it might be inevitable – this was always an overhyped element of the bull case for the stock, as I detailed back in July.
(Tesla shares are down 10% in premarket trading Tuesday following the S&P snub)
S&P Dow Jones Indices doesn’t explain its rationale for not adding a company, simply announcing the new entrants and deleted names (in this case, Etsy, Teledyne and Catalent in place of H&R Block, Coty and Kohl’s).
Yahoo addition in ’99
Yet S&P Dow Jones senior analyst Howard Silverblatt has recently noted the closest precedent for a potential Tesla index inclusion was the November 1999 addition of Yahoo – then a runaway high-flyer of the initial Internet boom, which soared 64% between its induction announcement and placement into the index.
It was part of the final blow-off top of the tech bubble, having come the same month Dow Jones capitulated to the tech dominance by adding Microsoft and Intel to the Dow Jones Industrial Average – its first-ever Nasdaq-listed members.
Tesla in many respects is its own phenomenon, given the velocity of the stock’s gains, avidity of its shareholder fan base and a valuation that is implicitly granting the company credit for many years’ worth of industry-transforming success.
Yet having to wonder about how its membership would unsettle an index that has become the single most popular means for investors to gain core exposure to U.S. stocks says plenty about the mechanics of today’s market. The common thought was that Tesla would issue shares in conjunction with joining the S&P 500 to make it easier for index funds to build the needed positions (something Facebook did as well).
The stock’s reaction last week to a $5 billion equity-sale arrangement – falling 17% from its Monday high after moving to offer just over 1% of its market capitalization at the time – might support the idea that index funds would be forced to buy the stock at a stretched and fragile price.
This leaves quite a bit of market value building up outside the S&P – which like many traditional investors has been hesitant to invite some of the biggest winners of today’s growth-stock love-fest into their portfolios.
Lots of hot stocks outside of S&P
Tesla, at $390 billion in market cap, would likely have placed 14th in the S&P, between Mastercard and United Healthcare. (S&P uses “float-adjusted” weighting, reflecting only publicly tradable shares, so Elon Musk’s 20% Tesla stake would not be accounted for in its index weighting).
Adding to Tesla’s market cap those of Shopify (likely ineligible as a Canadian company) and Zoom Video and it leaves more than $600 billion outside the benchmark, an amount that exceeds the market value of Berkshire Hathaway. Combine with non-U.S.-domiciled winners Spotify and Lululemon and this cluster approaches Facebook’s market cap.
There is some history to S&P maneuvering to make room for a bulge in newly created value outside the S&P. In 2002, the index keeper ejected non-U.S. listings (including at the time Unilever, Royal Dutch, Inco and others). It was viewed at the time, as a way to accommodate a group of large relatively newly public companies including Goldman Sachs, Prudential and United Parcel Service. So the dog has been wagged before.
Still, right now we also have the Dow Industrials adding Salesforce.com to pad its tech weighting after an Apple stock split. Online brokers experiencing network slowdowns reportedly due to the Apple and Tesla share splits last week. And an entire market fixated on the relentless buying of call options in tech, spilling into urgent hedging that has exacerbated index moves. And then Friday’s revelation of SoftBank as one of those buyers of huge quantities of upside tech exposure generated new issues about whether market infrastructure can handle a rush of speculative capital mostly rushing in one direction.
It’s probably too melodramatic to say the public’s appetite for tech threatens to eat the entire market and its major mechanisms. But directionally, it’s a legitimate observation, coming at a time when the growth-stock rally overshot in the short term.
The late-week 6% sell-off in the Nasdaq Composite reflects the two main tactical vulnerabilities: It became grossly over-extended technically and trader positioning grew too crowded on the bullish side. If there needs to be an “equal and opposite” recoil to take care of them, then last week’s setback probably wasn’t enough, but there’s no saying this is necessary at this point.
The short-term overheating and the headlong gains in earlier-stage concept stocks did little to change the equation for the prevailing mega-cap winners – copious free cash flow yields in a yield-starved and growth-challenged world.
But the hinky options-driven action, erratic speculative flows and stress on Wall Street’s index-investing and market-making machinery add a wilder element to what otherwise could be viewed as a routine correction in a powerful uptrend.