The Facebook Disease Might Have A Cure

Aug. 9.12 | About: Facebook (FB)

First of all, I need to say that Facebook (NASDAQ:FB) is somewhat expensive even where it trades today (below $21). Yet, Facebook is hardly the only expensive equity out there. Amazon.com (NASDAQ:AMZN) puts it to shame in that department, and it has imploding earnings and lead balloon estimates as well, which Facebook lacks. Salesforce.com (NYSE:CRM) easily does the same.

Yet, it is Facebook that falls day after day. Even on days, like yesterday (August 7), where the entire technology market shows great happiness. This wild divergence made me look a bit deeper into what was happening in the market. What's so different between Facebook and all those happy technology stocks? And what does it share with LinkedIn (NYSE:LNKD), which was also taken to the cleaners for a sound beating amidst all that happiness?

It turns out that Facebook and LinkedIn really share a few interesting characteristics. Namely:

  • Both are large capitalization stocks, with LNKD having a capitalization of at least $11.1 billion and Facebook having a market capitalization of at least $44.4 billion. I say "at least" because both can have more dilution not yet included in these numbers;
  • Both have insiders chomping at the bit to sell stock, both those whose positions are reportable, and a mass of employees whose sales aren't reported. So both of these stocks have constant new supply (Facebook's will increase as its lock up period expires);
  • And most importantly, neither of these stocks has a relevant Index membership. Sure, both are in the Russell 3000, but neither is in the Nasdaq 100 or the S&P 500.

And this last characteristic might well be the cause of the disease. By not being in the relevant indexes, a curious thing happens. Facebook and LinkedIn are shut out of seas of indexed and closet-indexed money. They're shut out not only from countless mutual funds, pension funds, insurance funds, etc, but they're also not bought by the leading ETFs, such as the PowerShares QQQ (NASDAQ:QQQ) for Nasdaq 100, and the SPDR S&P 500 (NYSEARCA:SPY) for the S&P500.

So, on days like yesterday, where the happiness might have been driven by a desire for higher equity allocations, Facebook and LinkedIn are dependent on the kindness of strangers to buy a few shares. The kindness of hedge funds that aren't indexed or closet indexed. And it so happens, that yesterday, such kindness was not there. There was buying in the markets, alright, but it seemed like it was all going towards the indexes.

When will this change?

At the very least, Facebook will likely get admitted to the larger indexes. I'd expect that around August 18 Nasdaq will admit it to the Nasdaq 100. Recently Nasdaq changed the rules so that the stocks didn't have to be public for two years to be eligible for Nasdaq 100 - only 3 months are necessary now. So with the Facebook IPO having been on May 18, the earliest that Facebook can be considered is August 18. Since Facebook direly needs this help to stabilize, Nasdaq probably won't be long in granting it.

Come August 18, it's possible that the announcement of Facebook entering the Nasdaq 100 could have a positive effect on the shares. However, the largest effect will be the stabilization of the stock and, from that point on, the increase in correlation between its movements and the market's. The positive effect of Facebook entering the index will probably be temporary and mitigated by more insider shares being unlocked for selling.

Conclusion

With Facebook's disease being that it can be incredibly volatile and trade deeply uncorrelated with the main indexes, it's to be expected that such disease will mostly be treated by its inclusion in those same indexes (Nasdaq 100 to start with). From there on, Facebook will probably trade a lot more correlated with other high multiple stocks such as Amazon.com or Salesforce.com. It should also lose a lot of its volatility.

There might be a long trade to be had right in front of August 18, however, such possibility is somewhat tempered by the possibility of insider selling into it.

Disclosure: I am short AMZN.