Freakout Friday: Broadcom's Jump Into S&P Likely to Roil Markets

The second quarter has been tough, and doubtless many investors are looking forward to laying it to rest. All the big indices, and most portfolios, are lower, and the urge to get a little rest and begin anew is strong. Plenty of people on Wall Street will be taking Monday off, stretching the weekend into a four-day affair. Even now, thoughts of Fourth of July barbecues are wafting over trading desks, drawing off attention.

But before the weekend comes, traders are going to have to get through Friday. And Friday? It's shaping up to be no fun at all.

That there will be a lot of churning Friday shouldn't come as any surprise. The final trading day of the second quarter is always a little weird: Not only do you have the typical window-dressing (the tidying up of portfolios that comes at quarter end), but also the annual rebalancing of the Russell 2000 index. Small-cap index managers will be scurrying to clear the Russell deletions from their portfolios, and to buy the additions.

It gets worse. After the close Friday, Broadcom (BRCM) will replace GTE (GTE) -- which is completing its acquisition by Bell Atlantic (BEL) -- in the S&P 500 . That could put serious selling pressure on the index -- and the market as a whole.

Standard & Poor's, when choosing stocks for the S&P 500, considers not just a company's market capitalization, but also its financial and operating condition. "The goal is to add companies to the index that are relatively stable and will keep turnover in the index low," is how S&P explains it. As a result, a company is not automatically added to the index once its market cap reaches the top-500 threshold, and if it is a highflier, it will often have to wait some time before it gets included.

This is what happened to Broadcom, a communications chipmaker whose stock has added more than 800% over the last two years. With a market capitalization of around $40 billion, it will come into the S&P (a cap-weighted index) ranked around 60th.

Billions and Billions Swerve

Because it will come into the index ranked so high, managers of funds indexed to the S&P 500 are going to have to buy a whole lot of Broadcom. There's about $800 billion indexed to the S&P, and indexers are going to have to buy around $2.5 billion worth of Broadcom, according to Merrill Lynch.

"In order to do that, they have to go and sell all the other stocks in the index," says Merrill equity derivatives strategist Diane Garnick.

"The S&P will be under price pressure that day," adds Murali Ramaswami, Lehman Brothers' global head of equity derivatives research. "It's almost like Yahoo! (YHOO)."

Yahoo! was added to the S&P on Dec. 7, 1999. Because it had such a big market cap -- around $94.5 billion -- indexers had to raise something like $4.5 billion to $5 billion, according to Ramaswami. That helped to send the S&P down 1% on the day. (Lehman estimates indexers will need to buy $3.2 billion to $3.3 billion worth of Broadcom.)

That this selling pressure is coming along with all of those other end-of-quarter thrills -- the Russell rebalancing, the window-dressing, the last minute run-ups and run-downs -- should make for an interesting day.

The weekend can't come fast enough.

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