Is the S&P 500 Now Cheap?

A WSJ OpEd by Jeremy "stocks for the long run" Siegel Wednesday was a little nutty. In essence he argues that the S&P 500 is cheap(er) if you weight earnings by market capitalization, instead of simply including them in the quarterly totals without regard to the percentage of S&P market capitalization made up by the company.

This is a permabull program for emphasizing good times and de-emphasizing bad times. It is always tilting toward making things appear cheap after the fact when stocks have declined/advanced (ex post), rather than being an accurate measure of the overall health of the companies in the index as constituted (ex ante).

To be marginally more charitable, at the very least Siegel should have recalculated the series over history to show what his new cap-weighted earnings multiple would look like. Trotting out a single adjusted figure with no context of what cheap now means in S&P 2.0 Siegel-world is meaningless.

Here is Siegel:

As the fourth-quarter earnings season draws to a close, there are an estimated 80 companies in the S&P 500 with 2008 losses totaling about $240 billion. Under S&P's methodology, these firms are subtracting more than $27 per share from index earnings although they represent only 6.4% of weight in the index. S&P's unweighted methodology produces a dismal estimate of $39.73 for aggregate earnings last year.

If one applies market weights to each firm's earnings using the same procedure that S&P employs to compute returns, the results yield a more accurate view of the current profit picture. Market weights produce a reported earnings estimate of $71.10 for 2008 -- nearly 80% higher than the unweighted procedure. The reason for this stark difference is that the firms with huge losses generally have extremely low market values and hence have a much smaller impact on the total earnings in the index.

Feel free to explain why Siegel's right, of course. I think he's mad.

Comments

[Roger Knights:]

There's a great book that deals with this sort of self-justification: "Mistakes Were Made (But Not by Me)" Here's the link to Amazon:

www.amazon.com/Mistake...

Feb 25 12:29 PM

[CAPT GW:]

Paul -- Thanks for the sanity. Btw, what is the real P/E on the S&P 500 index? The answers to that question that I get from numerous sources are ALL OVER THE PLACE, from less thn 10X to higher than 18X. Which is correct? And who has a good way to estimate the current PE and mesh it with the expected next quarter's anticipated S&P500 earnings? At <10X, I'd be a bull, especially if I thought that if the next quarter's losses were factored into that estimate. In the meantime, If the PE is around 15 or higher, then I'd be very cautious about being a long-term bull.

Feb 25 12:38 PM

[The Pragmat...:]

Siegel is wrong of course. Using annual PE ratios or annual earnings to "value" the market is an inherently flawed way of calculating valuations. This is because the analysts that create those estimates are inherently flawed. A cyclical10 year average is far more reliable and includes a much more reliable data set (Shiller's approach). Chart here: pragcap.com/shiller-st...

Feb 25 01:20 PM

[Steve in TN:]

I think Siegel is trying to justify the stock selection methodology in the ETF fund company Wisdom Tree, in which he is an officer.

Feb 25 02:01 PM

[wstevena:]

S&P methodology is correct and Siegel is wrong. The value of the portfolio (price*shares outstanding) is divided by the sum of (shares outstanding * earnings/per share) of all the companies in the index. Siegel wants it to be a weighted sum of P/E ratios, which overweights high market cap firms and underweights low cap firms. To actually realize the P/E performance that Siegel suggests is reasonable, one would have to either hold a levered portfolio overweight on the largest caps or one that shorts the lowest market caps. Good luck with that.

Feb 25 02:49 PM

[wstevena:]

x

Feb 25 02:52 PM

[sr9web:]

Siegal is correct. In a hypothetical scenario where you own some of each company, you will no doubt, own less $$ of the smaller market cap companies. If you didn't, you would be overwieghting the smaller co's and projecting that you own more of their losses than you do. If you bought a position right now in AIG and 19 other companies, you would not put 5% of your $$ into AIG, which very speculative right now. Therefore, you'd only on a small amount of AIG, so when the real numbers finally come out and we see that AIG is losing 100's of billions, it's barely a ripple in your portfolio, because you own only a few $$ worth of that crud. And if you don't, you are crazy. AIG is frittering it's value away in losses - another $60B in losses expected soon. But the market cap is only 1.25B. Even if you own 100% of AIG, you're not losing $60B, you are losing 1.25B. That other 58.75B doesn't get schmeared onto the rest of your portfolio. Rather, it disappears into the ether as AIG implodes.

Feb 26 02:00 AM

[contracontr...:]

The aggregate earnings calculated by S&P are not realistic profits applicable to S&P500 shareholders.

The S&P500 is not 1 company,shareholders are not liable for losses beyond the value of their investment in any particular S&P500 company.

Shareholders receive 100% of profits made by profitable companies. But they only partially participate on losses made by indebted and longterm-unprofitable companies.
Most of those companies tend to go bankrupt sooner or later and often a significant part of the losses incurred over the years or even decades is absorbed by creditors.
Therefore adding profits and losses together doesn't paint the real picture.

However Siegel's methology of marketcap weighted earnings is also flawed. The ever changing market cap also doesn't tell the percentage of losses applicable to shareholders.

Realistic earnings for the S&P500 are somewhere between those 2 methologies and can not be calculated exactly without making unscientific guesses.

Feb 26 07:18 AM

[Jeroen:]

Aren't earnings naturally cap-weighted? - a $90 bln dollar company makes $5 bln in earnings and a $10 bln dollar company makes $500 mln in earnings. So a cap-weighted index comprised of these two companies would have a value of 100 with 5.5 in earnings. If I would own these two companies outright, I would make $5.5 bln. in earnings, and not: ((0.9* 5 bln ))+ (0.1* 0.5 bln)) = $4.55 bln. Where does the other 0.95 bln. go? Sounds like black hole accounting....

It's not about weights, imo, but about normalized earnings vs non-normalized earnings.

Feb 26 08:47 AM

[Pau:]

Consider Morningstar's methodology:
"Morningstar calculates average price ratios for indexes and investment portfolios using the harmonic weighted average. This method compares the total market value of the portfolio to the portfolio’s share of the underlying stocks’ earnings (or book value, cash flow, sales or dividends). Morningstar prefers the harmonic method to an arithmetic weighted average, because outliers can easily skew the results of the arithmetic method."

Apr 13 10:55 PM