Google Stock Hits the S&P 500

Google Stock Hits the S&P 500


The Trader's U E-Letter: Issue # 181

Wednesday, March 29, 2006

Google Gets Promoted To the S&P 500: Does It Matter to Investors

by D.R. Barton, Jr., Chairman, Trader's U

I was casually watching my quote screen last Thursday after the regular session had closed when Google (Nasdaq: GOOG) shot up like a rocket.

I turned on CNBC - no news yet (no surprise, there). By the time my online news service filled me in on the announcement that Google was being added to the S&P 500 Index, the stock had already powered up 20 points. It went up 13 more points before settling back down to end the after-market session up 30 versus its close from the regular session.

It's clear Google hitting the S&P 500 was good news. And the media has been all abuzz about rebalancing the S&P 500.

But unless you were already holding some Google stock before the S&P news was announced, you've more than likely missed the majority of the benefit from the company's good news. So what is likely to happen next and what can investors do to profit and protect ourselves?

Logistics Of the S&P 500 Index - How It Operates and What Floats Its Boat…

To figure out what's most likely to happen next, we need to understand just a bit about how the S&P 500 Index and the funds that mimic it are constructed. When Google becomes an official member of the S&P 500 at the close of trading this Friday (3/31), index fund managers have some movin' and shakin' to do. This is because it will replace a much smaller stock and will therefore require more transactions than just selling all of the Burlington Resources stock in the fund and replacing it with Google. Let's see why…

Less than a year ago, the S&P 500 index was a market capitalization weighted index. (This means that the contribution any one stock in the index made to the price was a function of the stock's market capitalization.) In 2005, the S&P 500 transitioned to a float weighted index. Under the new system, the weight or percentage contributed to the index is not determined by multiplying price times outstanding shares (which equals market capitalization), but rather by price times free-floating shares.

Free-floating shares are those that are available to the general public for trading. This change was made so that companies that have a large percentage of their shares controlled by insiders (like Google does) would be represented more accurately.

So what does all this mean?

Index-related funds have to change their portfolios to reflect the change from ousted Burlington Resources (which is being removed because the company was purchased by ChevronPhillips) to newly anointed Google.

Credit Suisse First Boston estimates that in total, index funds will have to drop Burlington Resources by selling all of that stock that they hold, which is worth about $1.6 billion in total. They then have to buy $6.8 billion of Google stock. In order to make up the difference, funds will have to rebalance their portfolios by selling off $5.6 billion worth of other stocks.

A Billion Here, A Billion There… What a Rebalanced S&P 500 Means To Investors

In a Reuters article that appeared on MSNBC.com, a Standard & Poor's official stated that more than $1.1 trillion is invested in index funds that track the S&P 500. Selling $5.6 billion of S&P stock would theoretically mean a reduction of 0.51% or about 6.7 S&P points. The current daily range of the S&P 500 is 10.7 points. So all the blustery talk about rebalancing the S&P 500, while apparently a lot of work for some fund managers, doesn't mean a hill of beans to you and me in the short run.

In the long run, one could argue that the S&P 500 will be hurt if Google's value has been artificially and temporarily inflated by its addition to the index. If it falls to reflect its pre-addition value, then the index would be pulled down. But again, this effect should be minimal since Google will make up only 0.68% of the S&P based on its current stock price and number of floating shares.

The Bottom Line

For folks that do not have Google in their portfolio, the effect of its addition to the S&P 500 index should be minimal!

  • If you do hold Google stock: A sensible play might be to hold on through late Friday as stock is bought to add the search giant to fund portfolios. After that, probabilities are that Google could drift (or fall harder) back to its pre-addition pricing. However, one thing we know about Google is that it can be a volatile stock, so it's not likely to follow a straight path in one direction or the other.
  • If you do not own Google, but do own index funds: No need to panic. This event has already been priced into the index by traders and investors, and as our math shows, the event really should have minimal effect on the index.
  • If you are a gunslinger who can control risk: Several interesting areas of resistance are coming into play that could limit the upside on Google (see "The Chart of the Week" below for a visual view). Google is also overbought technically because of its current run-up. Add this to the end of the buying by index funds (which, again, will last through Friday, March 31), and you have a classic setup for a short sell. HOWEVER, this setup is only for experienced traders and investors. Many short sellers have had Google eat their lunch (and dinner, and dessert…) over the past year.

The math of this situation gives us some guidelines to follow, but remember that the markets are driven by trader and investor psychology, sentiment and actions. Don't get caught up in the media hype of this (or any other event), but be aware that others might!

Great trading,

D.R.

Today's Trader's U Tips & Tricks

  • How does the Internet sector look as a whole? What's Yahoo! up to? Find out why Dr. Mark Skousen, Chairman of Investment U, believes investors recently made a mistake selling off shares of Yahoo! In IU #506, How One Penny Sparked A 13% Collapse On Wall Street, Mark says Yahoo! will give Google a run for its money.
  • And for an interesting article (still relevant nine months later) on the mystique of Google, check out http://economist.com/business/displayStory.cfm?story_id=4135286

The Chart of the Week

Google (Nasdaq: GOOG) held the gap support zone described in this space last week, thanks in large part to its addition to the S&P 500 Index. It is now approaching key resistance areas between $397.50 and $406.50. If the good news from being added to the S&P can't help it clear these resistance areas, then a hard fall to test and eventually break the old gap support is probable.

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