History says that adding to the S&P 500 will have this impact on Palantir stock

There was a lot of excitement around the news that Palantir Technologies (PLTR 0.46%) would add to S&P 500 index. The index is widely regarded as the benchmark for US stocks, and there is an enormous amount of investor money tied to the index because so many exchange-traded funds (ETFs) and mutual funds track/mimic its performance.

Not surprisingly, when there is an announcement that a stock will be added to the S&P 500, it tends to see a nice jump in its stock price. The reason is pretty simple: S&P 500 index fund managers now have to buy all the stocks, which raises interest and helps drive up the stock price. Shares of Palantir, for example, rose more than 13% in the trading session after the news was announced. It will be officially added to the index on September 23rd.

How does inclusion in the S&P 500 affect a stock?

According to a study conducted by S&P Globalstocks added to the S&P 500 between 1995 and 1999 outperformed the index by 8.3 percentage points between the announcement date and the effective date, while stocks added to the index between 2000 and 2010 had an excess return of 3.6 percentage points during this period. This outperformance has been referred to as the “index effect”. Delisting has also been shown to have a negative effect on a stock’s performance, although the performance effect of delisting also matters less these days than it used to.

The S&P 500 “index effect” has diminished over time

Source: S&P Dow Jones Indices LLC, FactSet. *Graph is based on median excess returns of sample additions and sample deletions to the S&P 500 between January 1995 and June 2021. Performance period is from announcement date to effective date. pps = percentage points.

However, the index effect has disappeared more recently. Between 2011 and 2021, stocks added to the S&P declined by 0.04 percentage points between the announcement date and the effective date compared to S&P 500 returns. Meanwhile, stocks that were removed from the index during this time outperformed stocks which were added, generating an excess return of 0.06 percentage points over the index.

Meanwhile, after a stock is officially added to the S&P, it tends to underperform during the first 21 trading days it is in the index. From 1995 to 2021, new additions to the S&P have underperformed by nearly 1.7 percentage points. Similar to how the effect of the index declined, so did the underperformance of stocks immediately after their inclusion in the S&P. This can be seen with the stocks added to the index having a slightly negative comparative return of 0.12 percentage points between 2011 and 2021.

Average returns of the S&P 500 21-day sample additions after effective date

Source: S&P Dow Jones Indices LLC, FactSet. Note: Chart is based on median returns of sample additions to the S&P 500 between January 1995 and June 2021. Performance is based on stock price 21 days after the effective date. pps = percentage points.

One caveat with Palantir is that stocks that were not in any previous S&P index (such as S&P MidCap 400 or the S&P SmallCap 600) performed well between the announced date and the effective date. For the entire period analyzed by S&P, these stocks had excess returns of 6.2 percentage points, while outperforming by 4.3 percentage points between 2011 and 2021. However, the group still underperformed the index on a 21-day basis after being added by almost 2.5 percentage points over the entire period studied and by 0.75 percentage points from 2011 to 2021.

Given Palantir’s strong first-day gains after announcing its inclusion in the S&P 500, history tells us that the stock is likely to underperform over the next couple of months. However, there are certainly cases of very popular stocks that continue to skyrocket immediately after the announcement. For example, adze has seen its stock rise about 70% in 2020 after it was announced that it was entering the S&P.

Membership in the S&P 500 does not guarantee that a stock will perform well in the long term, or even in the short term. For example, Super Micro Computer the stock has tumbled since it was added to the S&P 500 earlier this year.

Longer term outlook

How well Palantir stock performs over the next few years will likely depend much less on its inclusion in the S&P 500 and much more on whether the company can accelerate its revenue growth. The main reason behind this is its valuation, with the stock trading at a forward price-to-sales ratio of more than 23 times analyst estimates for 2025. For a company that grew revenue 27% in Q2, that’s an incredible valuation of the sea .

PLTR PS report data (1 year ago) by YCharts

Thus, the key for Palantir will be to continue to accelerate its revenue growth from here. The company has done a very good job of growing US commercial revenue, driven by its artificial intelligence (AI) solutions. Meanwhile, US government revenue has improved, although it needs to grow faster to help justify the company’s current valuation. To help with this, it has partnered with Microsoft to deliver its solution using Microsoft’s various government cloud services.

That said, while Palantir is a great company, the stock’s valuation is a bit too frothy right now to make it a good buy. As such, I would let the hype of the S&P inclusion dissipate before considering buying the stock.