Monday, March 2, 2009

"Singularly Minded: Jeremy Siegel and the S&P 500"

"It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so."
-Mark Twain

Jeremy Siegel is back at it. Yesterday’s Wall Street Journal Opinion Column contained an article by Professor Siegel titled “The SP Gets its Earnings Wrong: Stocks are Cheaper than they Look”. For those individuals that follow Siegel, his conclusion that stocks are cheap is no surprise. About every three months or so for the past couple of years Professor Siegel writes an article/blog in which he argues why the S&P 500 is a fantastic bargain. What is surprising is that he has now shifted tactics. With reported earnings being decimated by over $300 billion in write-downs and operating earnings cracking across the board, the empirical evidence does not lend itself to the Professor’s bread and butter argument. Thus, instead of writing a piece titled ‘How I Missed the Finance Based Economies Shenanigans’ or ‘How My Equity Got Buried Under a Mountain of Debt’ or even ‘Deleveraging: Why I was the Last Person in the Room to See it’ (yes, the professor has not once addressed the issue of debt-driven deflation or even uttered the words deleveraging in one of his sp500 is cheap articles) Professor Siegel has decided to go after S&P and their method for calculating the indices P/E. Like all talented academics, the professor knows that valuation is an art and not a science. As the saying goes, if you can’t win the game, change the rules.

Professor Siegel believes that S&P’s ‘bizarre’ approach of aggregating earnings is making stocks look deceptively more expensive than they really are. His logic is really quite simple. The firms that lost all the money over the last twelve months were finance companies or automakers, and since those firms now make up a very small percentage of the S&P500; their disproportionately large losses are distorting the earnings power of the index. See, Professor Siegel wants to relatively weight the earnings of S&P 500 firms based on market capitalization. This way Exxon (which makes up 5% of the index) Mobil’s profits are not wiped out by AIG or GM’s (both of which now represent a tiny fraction of the index) losses. Since super large cap companies most likely are still super large caps because they are capable of making money or have yet to get hit hard by the downturn, relatively weighting their earnings will raise the S&P 500’s overall reported earnings. This in turn will lead to a lower reported P/E. To be frank, I have no problem with this approach. It would be nice to have weighted earnings data reported. What bothers me about this argument is that Professor Siegel was not recommending we market weight earnings when finance companies were producing a disproportionate amount of sp500 earnings growth or when technology stocks climbed to ludicrous valuations in 1999-2000. The professor doesn’t seem to consider the fact that the earnings multiples for the S&P500 in 1999/2000 would have been much higher than is historically recorded if a relative weighting approach was used. As all the NASDAQ listed companies in the index with little to no earnings, but insane market capitalizations, would have dragged down the indexes overall profitability.

We could play this game all day long, and I doubt that professor Siegel does not realize this. What concerns me is his flawed logic. S&P has a method for measuring earnings that is consistent, and that they have not significantly altered over the years. This allows us to make historical comparisons. Valuation has never been an absolute game. If the Professor is going to use a market weighting approach to comment on the relative attractiveness of the S&P500, then he must have a consistent historical data set to compare it to. You cannot use a new approach to come up with a more favorable current P/E and still compare that P/E to the average historical multiple that was calculated by the old approach.

If you want to make a persuasive argument attacking an established method, then you should be armed with some serious historical data. As a world-renowned finance professor, this would not be very hard thing for Mr. Siegel to do, and he could then publish his findings and have them out there for his peers to review. That would make for an interesting piece.

Instead, he seems to enjoy the role of Ben Stein or Jim Cramer in which he gets to publish quick notes to back up his “financial ideology” or “market cheerleading” and continue to monetize the media personality that he has created.