[The Street] S&P 500 Index Funds Will Pay Dearly for AOL.

I Find Karma (adam@cs.caltech.edu)
Thu, 24 Dec 1998 23:53:10 -0800 (PST)

Three deep-seeded implications of AOL being added to the S&P 500:

1. Expect the S&P 500 index funds to take a short-term hit as their
buying up AOL bids up AOL's price. Also, if & when the Internet stocks
come crashing down, AOL's weighting in the S&P 500 may trigger a
downward spiral as it pulls other stocks down with it. On the other
hand, if AOL continues to outperform, it's going to be harder than ever
for mutual funds to beat the S&P 500. After all, just 10 of the 500
stocks in the index are responsible for half of the S&P 500's growth
this year.

2. This move gives a big boost to the legitimacy of Internet stocks in
general as the first to be introduced to the S&P500 -- the other day I
incorrectly identified AMZN as being in the S&P 500 but I was wrong (it
is instead in the NASDAQ-100, as is YHOO -- excuse my brain bubble).

3. On the other hand, this move starts to tie the fate of the market
to the fate of the Internet. As we go into 1999, the average S&P 500
company's P/E is higher than the average P/E in 1929 and 1987 just prior
to their crashes. We could attribute this to the ever-increasingly
ignorant investing public signing on to the Internet, getting online
brokers, and buying a few select stocks while the remainder of the
market lags way behind. Think how stupid the average investor is, and
then remind yourself that half of all investors are stupider than that.
These ignorant fools are gonna panic at the first sign of trouble, and
if there's no institutional investor support to accommodate their panic,
look out below.

At AOL's stock's current growth rate, America Online's market cap will
pass $100 billion sometime in 1999. This will make it one of the top 20
largest U.S. stocks by market cap. Frightened yet? When people said a
year ago that AOL would be the next Microsoft, no one took them
seriously. Now that AOL is 5 times the market cap it was a year ago
(currently $63b), it is bigger than Ford, GTE, Disney, Time Warner,
McDonald's, American Express, Oracle, Motorola, Xerox, Boeing,
Anheuser-Busch, or Sun... by December 31's bump, AOL will be bigger than
Hewlett-Packard, MCI WorldCom, or Compaq. Now are you frightened?

Remember the theory I had where I thought that new people who get on the
Internet to invest buy the stocks of the companies they use to get on
the Internet and invest? Look at this year's performance of the stocks
of Yahoo!, Amazon, eBay, eTrade, Ameritrade, Schwab, Earthlink,
Mindspring, and America Online, and tell me I'm wrong...

> Index Funds Will Pay Dearly for Newest Member of S&P 500
> By Joe Bousquin, TheStreet.Com Staff Reporter, 12/23/98 5:53 PM ET
> Here's a chance for active mutual fund managers to gain some ground on
> the indexers.
> Tuesday's announcement by Standard & Poor's that it would add America
> Online (AOL:NYSE) to its S&P 500 index will surely cause a rash of
> trading in that stock Dec. 31. At the close that day, AOL will
> officially become listed. Index fund managers, who try to match the
> returns of the index as closely as possible, will want to get in as of
> that moment.
> With AOL trading at an all-time high at one point today of $141, those
> managers will have to pay dearly to get it.
> "Looks like they'll be buying it at the top," says David O'Leary, of
> Alpha Equity Research in Portsmouth, N.H.
> Consider the mammoth, $70 billion Vanguard Index 500 fund. With AOL set
> to comprise about 0.6% of the S&P 500's total $9.7 trillion market cap,
> the fund will need to match that weight in its portfolio. That works out
> to about $420 million worth of AOL stock that Gus Sauter, the Vanguard
> Group's human being behind the huge indexing machine, will need to buy.
> Sauter says in order to match the returns of the index closely, he won't
> start buying AOL until about 1 p.m. on Dec. 31. At 138 1 /2, AOL's
> closing price today, that would translate into about 3 million shares of
> the stock for his portfolio.
> With more than 25 million shares of AOL exchanged today (average daily
> volume is 14.7 million shares), he probably won't have a problem getting
> those shares, but he will have competition for them. After all, there
> will be about 100 other S&P 500 index funds trying to get those shares
> at the same time, so chances are Sauter will be paying a premium. But in
> many aspects, that is simply the nature of the indexing game.
> As AOL's stock has risen 512% this year, many active fund managers have
> ridden the stock to keep pace with -- or even beat -- the S&P 500.
> Selling it now will give those active managers an opportunity to take
> profits, while indexers will be forced to buy high.
> "The timing is bad for anybody indexing, but the timing is good for
> anybody actively managing the portfolio" with AOL, O'Leary says,
> "because [AOL] has helped them beat the index on the way up, and now
> they have an opportunity to sell it at $138 per share."
> Sauter says there's another factor about AOL that will affect index
> funds. America Online has a market cap of $63.4 billion, an unusually
> large market cap for an "add" to the S&P. The companies Sauter usually
> buys on an add to the index are around $15 billion in market cap, he
> says.
> "Most indexers are going to have to sell off some stocks to raise cash
> to buy AOL," Sauter says. "We're certainly going to have to divert a lot
> to AOL. It's a big position. It's a large company."
> And Sauter also knows that those indexers probably will see short-term
> declines in the stock after its initial boost from being added to the
> index wears off.
> "We do see over the following month that the price does tend to go back
> down," he says about stocks added to the index.
> But over time, the S&P 500 Index has tended to go up, which is what
> indexers are betting on. And with their kind outperforming almost nine
> out of every 10 active fund managers this year, don't look for indexers
> to have egg on their faces anytime soon.


With the window cracked, holler back, "money ain't a thang."
-- Jay-Z featuring Jermaine Dupri