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March 17, 2009 |
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Siegel: S&P Methodology Is Flawed |
Does Standard & Poor’s underestimate the earnings of its S&P 500 Index? Or does one of the nation’s most prominent finance scholars deserve an “F” in index arithmetic?
Those are the questions investors have been left with after a recent tussle between Standard & Poor’s and Jeremy Siegel, a finance professor at the University of Pennsylvania’s Wharton School of Business and author of Stocks for the Long Run.
The dustup started when the Wall Street Journal ran an op-ed piece by Siegel that argued Standard & Poor’s uses a “bizarre” methodology for calculating the earnings and P/E ratio for the S&P 500.
Siegel explained that the earnings of S&P 500 companies are currently treated equally, but should instead be weighted in proportion to their market capitalization.
Market capitalization weighting, he noted, is used to measure the S&P 500 returns.
Such a system, he stated, would give larger weight to the earnings of a company such as Exxon-Mobil, and lower weight to an S&P 500 member such as Jones Apparel.
“In fact, a 10% rise in Exxon-Mobil’s price would boost the S&P 500 by 4.64 index points, while the same fall in Jones Apparel would have no impact since the change is far less than the one-hundredth of one point to which the index is routinely rounded,” Siegel wrote.
If capitalization weightings were applied to 2008, he noted, the earnings of S&P 500 companies would have been $71.10 per share instead of $39.73 per share.
“No one can deny that the recent economic downturn has badly hurt corporate earnings. But let’s not fool ourselves into thinking that this is an expensive market,” Siegel said. “When computed accurately, P/E ratios show that this market is much cheaper than is currently being reported by the S&P.”
The opinion piece by Siegel—well known in the investment community for his consistently bullish stance on stocks—triggered a wave of Internet chatter, as well as a reply from Standard & Poor’s.
In the response, an S&P official said Siegel’s argument “fails the test of both logic and index mathematics.”
David Blitzer, S&P’s managing director and index committee chair, argued in his letter that, where earnings are concerned, market capitalization is irrelevant.
“A dollar earned or lost is the same irrespective of whether it is earned or lost by a big index constituent or a smaller one,” he argued.
Turning Siegel’s example on its head, Blitzer pointed out that if Exxon-Mobil earned $10 billion, and Jones Apparel lost $10 billion, investors would bear a proportionate share of each regardless of market cap.
The correct way to look at S&P 500 earnings, Blitzer said, is to look at the index as a single company with 500 divisions.
“The smallest of these divisions could have an outsized loss that wipes out the combined earnings of the entire company,” he said. “Claiming that these losses should be ignored or minimized because they came from a less valuable division is flawed.”
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