Will the S&P Change Tesla, Or Vice Versa?

By admin_45 in Blog

Now that Tesla is finally in the S&P 500, there’s some attention around the question of what adding such a volatile stock might do to the index’s own stability.

Let’s start an answer with a little math:

• Tesla is 1.6 percent of the S&P.
  
  While that is more than Berkshire Hathaway (1.4 pct) or Johnson & Johnson (1.3 percent), it is still far less than Apple (6.6 pct), Microsoft (5.4 pct), Amazon (4.4 pct), Google (3.3 pct) or Facebook (2.1 pct).
• Over the last year, TSLA’s average 1-day move (up or down) has been 4.1 percent, which is 4x the S&P 500’s 1 percent long-run standard deviation of daily returns. On top of that, Tesla’s stock has moved more than 10 percent in a day 24 times in the last 252 trading days (aka one calendar year).

Combine these 2 points and they show that Tesla’s influence on the volatility of S&P 500 returns is all of 6 basis points at the mean (1.6 percent weighting x 4.1 percent) and 16 basis points on a spicy day (+/- 10 percent) for the stock. Not much, in other words.

As we considered this topic, however, Jessica and I got to wondering 1) if S&P 500 inclusion drives newly-added stocks to trade more in line with the index, and 2) if index inclusion correlates with a company hitting some level of “seasoning” that foreshadows lower future stock price volatility. To dig a little deeper on those questions, we:

• Pulled the daily price data for Facebook, Amazon and Google for a year before their inclusion in the S&P 500 through the first 2 years after that date.
  
  While these companies were nowhere near as large as Tesla on their inclusion dates, they are the 3 best examples we have in terms of adding already well-understood disruptive companies to the index.
• Calculated trailing 30-day standard deviations of daily returns to measure volatility across this 1-year back/2-year forward window spanning S&P 500 inclusion.
• Also measured 90-day correlations of daily price returns for FB, AMZN and GOOG versus the S&P 500 across this 3-year period.

Here is what we found:

Facebook (added to S&P 500 December 23rd, 2013):

• In the year leading up to its S&P inclusion, FB’s stock was remarkably uncorrelated to the S&P 500 at just 0.20 (r-squared of just 4 percent). The standard deviation of its daily returns was 2.7 percent.
• In Year 1 after its inclusion, FB’s correlation rose to 0.53 (r-squared 28 percent) and its volatility fell to a 2.2 percent standard deviation of daily returns.
• In Year 2, the stock’s correlation to the S&P 500 rose further to 0.60 (r-squared 36 percent) and its volatility declined further to a 1.6 percent standard deviation of daily returns.

Takeaway: Facebook’s stock price action pre- versus post-S&P 500 inclusion is what you’d expect to see – higher levels of stock price correlation to the index over time combined with lower levels of volatility after it is added to the index.

Google (added April 3rd, 2006)

• In the year before its S&P inclusion, GOOG also showed little correlation to the S&P 500 at 0.29 (r-squared of 8 percent) and was less volatile than FB with a standard deviation of daily returns of 2.1 percent.
• In Year 1 after its inclusion, GOOG’s correlation to the S&P 500 rose to 0.45 (r-squared of 20 percent) and volatility fell to a 1.7 percent standard deviation of daily returns.
• In Year 2, its correlation rose further to 0.53 (28 percent r-squared) and volatility stayed the same as Year 1 (1.7 percent).

Takeaway: same story as Facebook here. Post-S&P 500 inclusion GOOG saw higher correlations to the general equity market over time and lower levels of stock price volatility.

Amazon (added November 18th, 2005)

• In the year before its inclusion, Amazon was the most volatile of the 3 names we’re discussing today with a 2.2 percent standard deviation of daily returns. It was, however, more correlated to the index than either FB or GOOG at 0.43 (19 percent r-squared).
• In Year 1 after inclusion, AMZN’s volatility actually rose slightly to a 2.3 percent standard deviation of returns and its correlation also increased slightly to 0.48 (23 percent r-squared).
• In Year 2, AMZN’s volatility rose further to a 2.8 percent standard deviation of daily returns and its correlation to the S&P fell slightly to 0.46 (21 percent r-squared).

Takeaway: this one needs some explaining, because after entering the S&P 500 AMZN was more volatile than pre-inclusion and saw no incremental correlation to the overall US equity market. The reason is actually quite simple: Amazon had some pretty wild volatility in 2006 and 2007, with 5 days where its daily price move exceeded 10 percent and was as high as 27 percent (April 25th, 2007, when it beat earnings and announced a stock buyback).

As far as what these 3 case studies mean for Tesla’s impact on S&P 500 returns/volatility, the right question to ask is “does Tesla more closely resemble Facebook and Google, or is it Amazon?” In the first 2 cases, history says TSLA’s volatility should decline and its correlation to the index should rise over the next 2 years. In the last case, TSLA may well remain volatile and relatively untethered to the index.

Not to undo the comforting math with which we started this section, but we think Amazon is undoubtedly the right comparison as we consider how Tesla will trade now that it’s in the S&P 500. Both companies are run by visionary founders. Both companies focus less on predictable profits than fulfilling larger goals. One could even argue that Tesla is less shareholder-focused than Amazon, given the latter’s relatively infrequent equity offerings.

In the end, however, we need to remember that Tesla is still a small fish in the ocean that is the S&P 500. Yes, it is representative of the animal spirits that drive marginal stock prices for a host of disruptive names. But it is still just 1.6 percent of the S&P 500.