Jeremy Siegel: More Right than Wrong

In Wednesday's WSJ, Wharton Professor Jeremy Siegel wrote an Op-Ed, “The S&P Gets Its Earnings Wrong” (subscription required - e-mail me for a link), arguing that the way S&P calculates earnings is wrong and therefore stocks are much cheaper than most believe. It has generated a lot of attention in the blogosphere and the bears are ripping Siegel limb from limb. Here are some examples:

• “Jeremy Siegel, Wrong”, Henry Blodget
• “Are S&P Earnings Wrong?”, BeSpoke Investment Group
• “Jeremy Siegel’s Silly P/E”, Felix Salmon, Market Movers
• “Jeremy Siegel Reinvents S&P 500 - Declares It Cheap”, Paul Kedrosky, Infectious Greed

Due to huge losses by financials and a few other companies, 80 companies, making up 6.4% of the market cap of the S&P 500, with $240 billion in losses for 2008 are deducting $27 in earnings from the S&P 500 causing overall earnings to be about $40 for 2008. Based on today’s closing price of 752 on the S&P, that would give it a trailing P/E of 19 - well above its historical average around 15. So, the bears claim: Stocks are not cheap!

Siegel argues that just as the price of the overall index is weighted, earnings should be also be weighted by market cap because that gives a more accurate picture of valuation. I haven’t really been able to think through whether or not that’s right, but the underlying point he is making is that multi-billion dollar losses by the financials are distorting the overall valuation picture. This explains why almost every time I analyze a non-financial company, I’m impressed by the exceptional value now available.

One way to think about the value available outside of the financials is to consider the P/E for all profitable companies in the S&P. That is, let’s just remove those 80 companies and their $240 billion in losses. If we do that, we have 704 points of the S&P’s market cap (93.6% * 752) and $67 in earnings for a trailing multiple of 10.5. In other words, that’s the P/E for the S&P 420 - the 420 companies that made money in 2008.

That’s much more in line with the companies that I’m looking at it. And seriously, who cares about the financials? They aren’t investments anymore - they’re speculations on their very survival and on government policy.

The point can be made very clearly by constructing a very small index consisting of Citigroup (C), Wal-Mart (WMT) and Hewlett Packard (HPQ).

• Citigroup has a market cap of about $14 billion and lost $18.7 billion in 2008.
• Wal-Mart has a market cap of about $190 billion and made $13.4 billion in 2008.
• HP has a market cap of about $75 billion and made $8.3 billion in 2008.

The total market cap for this index is $279 billion and the total earnings are $3 billion for a trailing multiple of 93. What an expensive index! With a trailing P/E of 93, only permabulls could think stocks are cheap. But, in fact, the overall P/E of the index is a meaningless number. What we have is a large piece of crap (Citigroup) and two attractively valued stocks (WMT (P/E: 14) and HPQ (P/E: 9)). And that, in a nutshell, is what is going on with the entire index.

The bears are gorging on Siegel’s carcass, but he’s more right than wrong…

Comments

[Vox Rationalis:]

Well said - you've almost got it perfect. The key here is that the worst financials are skewing the overall measure by MORE than the worst dogs usually skew the overall measure. I think it's probably much more.

What I'd like to see is a historical analysis of the S&P 500 with the worst 10 performers removed, and another with the best 10 and worst 10 removed. I'd bet that under either scenario, our current market would not be expensive in historical terms.

Feb 27 07:51 AM

[Prudent Man...:]

Sorry, can't "Cheery Pick" if you are trading or investing in an index.

I don.t believe that anyone, especially those at Goldman, have enough information in order to make a sensible estimate. The variables of interest rates, and their friend inflation, taxes, Socialism, attitudes, confidence, etc. are to difficult, if not impossible to determine.

Those who manage other peoples money are having enough brown nosing to do just to keep their jobs without investing new money. Those of us who have been in the business for decades know that just keeping your clients, those who pay ones salary, is a larger project than anything they have ever experienced.

Feb 27 09:13 AM

[Ferdinand E...:]

So Jeremy Siegal is a professor at Wharton? Sounds great to me, because I have had some dealings with an 'energy expert' at Wharton (or Penn or something), and that gentleman is hopeless. Am I familiar with Professor Siegal's work? You bet that I am. I mention it in a finance textbook I published a few years ago, in the course of which I made it clear to my students that they were never to mention his fairy tales about stocks.

Feb 27 09:27 AM

[Vox Rationalis:]

An alleged CFA wrote:

"Sorry, can't 'Cheery Pick' if you are trading or investing in an index."

What are you talking about? The S&P 500 is used as a proxy for the market as a whole. Could some other basket of stocks serve this purpose? Of course. Why couldn't it be the S&P 500 less the top 5% and bottom 5% of performers (weighted) over the previous year?

Or how about this - instead of a mean earnings number (which is what is used), use a weighted median. That way outliers (and right now we have some SERIOUS outliers) wouldn't skew the measure of the overall market's performance.

Feb 27 10:05 AM

[Heaven, Hel...:]

One thing to keep in mind here with respect to gauging the extent to which stocks are cheap or expensive under Siegel's market weighted methodology, the long-term historical average of the S&P 500 P/E also needs to be recalibrated vis-a-vis its current level of 15.

Feb 27 01:11 PM

[TA:]

Well said...

Feb 27 07:37 PM

[kotika98:]

ok, wondeful. So, the 2008 S&P earnings are due to the large cap oilcos. That was the year oil went to $140, remember. Lets see how much they can make with oil at $35, while paying $600K every single day for those drilling rigs.

Feb 28 08:31 AM