Reddit's S&P 500 Bump: Don't Chase the Rally

Reddit (RDDT) is set to join the S&P 500 index on Tuesday, replacing AvalonBay Communities (AVB), which is being acquired by Equity Residential (EQR). The announcement, made Thursday evening, sent Reddit shares soaring about 13% on Friday, trading near $179. This surge reflects investor anticipation that index funds tracking the S&P 500 will be forced to buy Reddit shares, creating a temporary demand spike.

However, the stock remains roughly 37% below its 52-week high of $282.95, indicating that the broader market has been cautious about Reddit's valuation and growth prospects. The inclusion news provided a short-term boost, but the underlying business challenges remain.

Historical research by Harvard Business School professors Robin Greenwood and Marco Sammon shows that the 'index effect'—the abnormal return from joining the S&P 500—has been shrinking over the decades. In the 1980s, additions gained an average of 3.4%, which swelled to 7.4% in the 1990s. But by the 2010s, the effect had faded to less than 1%, statistically indistinguishable from zero.

For companies like Reddit that jump directly into the index from outside smaller benchmarks, the effect has been more pronounced but still declining. Direct additions returned 10.2% in the late 1990s, 8.8% in the 2000s, and 5.4% in the 2010s—though that number is inflated by Tesla's massive 2020 inclusion rally. Excluding Tesla, the average for 2020 additions was essentially zero.

The fading effect is attributed to structural changes: more companies now migrate from the S&P MidCap index, where index funds already own them, and the market has become better at supplying shares to meet forced buying. Additionally, anticipation plays a role, with stocks climbing an average of 18.7% in the 100 days before announcement in the 2010s, up from 9.6% in the 1990s.

The index inclusion rally is likely to be short-lived. Historical data suggests that once the forced buying subsides, the stock's price will revert to what the business fundamentals justify. Reddit's revenue has grown over 60% year over year for eight consecutive quarters, reaching $2.8 billion in trailing twelve months, and the company is profitable with $871 million in net income. However, the stock trades at about 40 times earnings, a valuation that assumes continued high growth.

A key risk is Reddit's dependence on Google for traffic. Two weeks ago, the stock sank after management warned of choppy search referral traffic, as Google's AI-generated answers reduce click-through rates. This structural headwind could slow growth and pressure the stock's premium valuation.

The S&P 500 inclusion does not change these fundamentals. It only provides a temporary boost from index fund buying. Investors should be cautious about chasing the rally, as the historical record shows that the index effect has diminished over time, and Reddit's business faces real challenges.

For AvalonBay and Equity Residential, the news is more straightforward. AvalonBay is being removed from the index due to the acquisition, but historical data shows deletions have minimal impact in recent years (0.6% in the 2010s). Equity Residential's acquisition is a strategic move that could create value, but the immediate impact on its stock is likely neutral.