Why I Think Jeremy Siegel's Argument Is Flawed

by: Toro

Jeremy Siegel is defending criticism of his argument that Standard & Poor's is incorrectly calculating market profits. Siegel argues that profits within the S&P 500 index should be weighted according to market capitalization, not on an absolute basis as Standard & Poor's currently constructs the estimate of aggregate earnings. Thus, AIG, which has a tiny market cap but a massive loss should have its loss scaled down to the company's relative market cap when tallying up the earnings estimate for the entire index. Using Siegel's methodology, earnings for the S&P 500 in 2008 would have been $71.50, not $14.97.

I think this argument is flawed.

Aggregate output in the economy is not calculated based on relative aggregate firm values. Aggregate output is aggregate output, irrespective of theoretical firm values. Aggregate profitability is a function of aggregate output, not a function of theoretical aggregate firm value. Thus, profitability should be viewed holistically.

Let us look at a hypothetical economy of two stocks, both represented in an index. Company A earns $1 and has a market capitalization of $100. Company B earns $2 and has a market capitalization of $20. Company A has a price/earnings ratio of 100x while Company B has a P/E of 10x. The two companies earn $3 in aggregate and have a market cap of $120, giving the index a P/E of 40x.

However, according to Siegel, Company A's profits should be scaled according to its market capitalization. Thus Company A's earnings should comprise 83% of aggregate profits ($100/$120) while Company B should comprise 17%. Using Siegel's methodology, multiplying Company A's earnings of $1 by 83% and Company B's earnings of $2 by 17% then totaling the two gives us an aggregate earnings figure of $1.17. Yet actual profits were $3, not $1.17. The P/E of the index using Siegel's methodology would be 103x ($120/$1.17), not 40x. How is this an accurate reflection of the true profitability and valuation of the index?

Such a methodology may have other perverse effects. At the peak of the Technology Bubble, tech accounted for roughly 35% of the market capitalization of the S&P 500 but only 15% of aggregate index earnings. If one were looking for yet another reason to rationalize the insane valuations of technology stocks at the time - as so many were - some enterprising strategist could have argued that using Siegel's methodology would have made the technology sector look cheaper. Since the market cap of tech was 35%, adjusting for market cap, tech's profits should have been scaled up to 35%, bringing sector valuations down. Ergo, tech stocks were cheap!

I do have sympathy with Siegel's underlying premise that write-offs in the financial sector have vastly distort the underlying profitability of the S&P 500. I use $70 as the normalized earnings of the market, which is close to Siegel's figure when he constructs the market cap-weighted earnings. However, valuation is ephemeral and using it to scale aggregate market profitability is not an accurate reflection of aggregate profitability in neither the index nor the economy.