In yesterday’s (Wed, 2/25) WSJ, Wharton Professor Jeremy Siegel wrote an Op-Ed arguing that the way S&P calculates earnings is wrong and therefore stocks are much cheaper than most believe: “The S&P Gets Its Earnings Wrong” (subscription required – e-mail me for a link). 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. And so the bears claim: Stocks are not cheap!
Siegel argues that earnings should be weighted by market cap just like the price of the overall index is and that that gives a more accurate picture of valuation. I haven’t really been able to think through if that’s right or not 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 everytime 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 also be made by constructing a very small index consisting of Citigroup, Walmart and Hewlett Packard. Citigroup has a market cap of about $14 billion and lost $18.7 billlion in 2008. Walmart 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 multipe of 93. What an expensive index! Who could think stocks are cheap? With a trailing P/E of 93! Perma-bulls!!!!
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 carcus but he’s more right than wrong…..
UPDATE (Fri 2/27, 12:30pm PST): Joe Weisenthal had some nice things to say about this post at Silicon Alley Insider: “In Defense Of Jeremy Siegel”.