What happens when a stock is added to the S&P 500

Palantir joined the S&P 500 on September 23, but recent data indicates the S&P 500 effect is not what it used to be

• The “index effect” occurs when a stock gets a short-term price increase after being added to a major index like the S&P 500. It is driven by increased demand from index funds and other passive investors.
• Studies show that the index’s effect has become less pronounced since 2010, with average stocks exhibiting less volatile behavior before and after its inclusion.
• Being included in the index reflects a company’s success, but does not guarantee growth. Strong fundamentals remain the key to long-term performance.

In early September, Palantir (PLTR) was trading steadily around $30 per share. But in just 10 days of trading, shares surpassed $37, marking an impressive 23% increase.

The catalyst? Not a big earnings report or groundbreaking product launch, but the simple announcement that Palantir will soon join the prestigious S&P 500.

This type of rally – driven solely by news of index inclusion – raises an important question: Is membership in the S&P 500 truly a sign of long-term growth or is it just a temporary boost fueled by short-term demand from index funds and passive investors?

To answer this question, we need to step back and analyze broader trends.

Big gains aren’t exclusive to S&P 500 stocks

The “index effect” refers to the market phenomenon in which a stock’s price undergoes a significant change – typically an upward spike – when it is added to a major stock index such as the S&P 500 or the Nasdaq 100. This effect It is driven, in part, by buying pressure from index funds and exchange-traded funds (ETFs) that are required to buy shares of newly created companies. This sudden increase in demand often drives up prices.

A detailed analysis of the index effect by the Federal Reserve produced some fascinating insights. One was that stocks added to major indices tend to exhibit “extraordinary pre-event performance.” In this case, the “event” refers to the official listing of the action, often called the “effective date.” or ED

The study, which examined company data that the 562 companies added to the S&P 500 between October 1989 and October 2009. On average, the companies experienced a 56% increase in market capitalization during the two years leading up to their inclusion, after adjusting for broader market trends.

When the study says “adjusted”, it means that the increase in market capitalization has been normalized to take into account global market fluctuations. This ensures that the 56% value reflects the company’s individual performance, separate from general market movements.

The study also indicated a similar increase in earnings per share (EPS), which increased by an average of 57% in the fiscal years before and after the inclusion. This close alignment between EPS growth and market capitalization underscores how companies selected for the S&P 500 typically demonstrate sustained financial success and market visibility. Recent examples like Supermicrocomputer (SMCI) and Palantir Technologies (PLTR) fits perfectly into this pattern.

Supermicro, which was added to the S&P 500 in March 2023, enjoyed meteoric growth before facing scrutiny from regulators over alleged accounting issues. Even with this decline, shares continue to rise by more than 2,000% in the last five years. Palantir, on a similar trajectory, is up 365% since its direct public offering, or DPO, in 2020.

However, the Fed study also revealed a critical conclusion: there is no permanent benefit from the index effect. While inclusion may trigger a short-term increase in share price due to increased demand from index funds, this effect is temporary. Over time, it disappears.

The study also showed that companies with similar financial trajectories that were not included in the S&P 500 showed comparable changes in stock prices. While inclusion in the S&P 500 generates initial excitement, it does not result in a lasting increase in a company’s value.

These findings were repeated in a similar study conducted by S&P Global, which further supports the idea that the index effect is more of a short-term phenomenon than a lasting advantage for companies.

Why the index effect isn’t what it used to be

Like the Federal Reserve, S&P Global conducted in-depth research into the index effect. As the owner and operator of the S&P 500 through its S&P Dow Jones Indices division, S&P Global is positioned to analyze the influence of index inclusion on stock performance.

A revealing aspect of the study was its examination of stock performance between the announcement date (AD) – when a company’s inclusion in the index is made public – and the effective date (ED) – when the stock is officially added to the index.

To get a clearer perspective, S&P Global measured excess return, which it defines as the difference between a stock’s total return and the overall return of the S&P 500. This approach, like the Federal Reserve’s, tracks broader movements in the market, providing a more accurate analysis. image of a stock’s specific response to its inclusion in the index.

The results of this examination demonstrate that the index effect has become significantly less pronounced over time. From 1995 to 1999, the average excess return on stocks added to the S&P 500 was 8.32%. However, from 2000 to 2010, this number dropped to 3.64%. From 2011 to 2021, the excess return has declined to almost nothing, a negative 0.04%.

Post-enrollment performance exhibited a similar pattern. The shares were valued over a 21-day period after the effective date and from 1995 to 1999 recorded an average negative return of 4.50%. From 2000 to 2010, this negative effect decreased to minus 1.69% and, from 2011 to 2021, it almost disappeared, falling to minus 0.12%.

As illustrated above, S&P Global’s findings indicate that the market reaction to index inclusion has weakened considerably since 2010. Stocks that once saw large pre-inclusion gains and post-inclusion pullbacks are now posting much less dramatic moves (on average) . This trend reflects the changing dynamics of passive investing and the broader market’s reduced sensitivity to index-related events.

Strong fundamentals trump index inclusion

Data from several studies paint a clear picture: although the index’s effect remains, its power has become significantly less pronounced.

Consider Palantir and Erie Compensation (ERIE), both added to the S&P 500 on September 23, 2024. In the 10 trading days before the addition, Palantir was up 23%, while Erie saw a more modest 3% gain. Since officially joining the index, Palantir shares have risen another 15%, while Erie has fallen 12%.

This stark contrast highlights the variability of the index effect: while some companies experience a clear increase in demand and visibility, others see little or no tangible benefit, as highlighted below. In fact, the broader data shows that more companies tend to exhibit behavior similar to Erie’s modest gains or declines rather than Palantir’s remarkable performance.

The key takeaway is that a company’s long-term performance is driven much more by its underlying fundamentals than by the short-term effects of index inclusion. Companies like Palantir, with strong profit growth and market share expansion, are already on an upward trajectory. Being added to a major index can accelerate your rise, but it is not the root cause of your success. On the other hand, a company like Erie with less momentum may not reap the same benefits even after joining the S&P 500.

This highlights a critical point: inclusion in the index is often a reflection of a company’s established success, rather than being the catalyst for it. Strong stocks tend to perform well on their own merits, with the index effect serving as a short-term amplifier rather than a long-term booster. For investors, this means that the best strategy for sustained growth continues to focus on a company’s fundamentals – its profits, growth potential and competitive advantages – rather than relying on the manufactured (and often temporary) momentum that comes with inclusion in the index.

Andrew Prochnow has over 15 years of experience trading the global financial markets, including 10 years as a professional options trader. Andrew is a frequent contributor to lucky box Magazine.

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