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Siegel: S&P Methodology Is Flawed

March 17, 2009 • Page 2 of 2

In the response, an S&P official said Siegel's argument "fails the test of both logic and index mathematics."

David Blitzer, S&P's managing director and index committee chair, argued in his letter that, where earnings are concerned, market capitalization is irrelevant.

"A dollar earned or lost is the same irrespective of whether it is earned or lost by a big index constituent or a smaller one," he argued.

Turning Siegel's example on its head, Blitzer pointed out that if Exxon-Mobil earned $10 billion, and Jones Apparel lost $10 billion, investors would bear a proportionate share of each regardless of market cap.

The correct way to look at S&P 500 earnings, Blitzer said, is to look at the index as a single company with 500 divisions.

"The smallest of these divisions could have an outsized loss that wipes out the combined earnings of the entire company," he said. "Claiming that these losses should be ignored or minimized because they came from a less valuable division is flawed."

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RDO 14 years ago

S&P methodology

Seigel is correct (in my opinion), but S&P has the history to make comparisons.To me, the most important question is related to the definition of earnings.If we use operating earnings (earnings before the bad stuff), we get a reasonable PE but, in the long run, you have the potential or likelihood of cumulative damage to the balance sheet that can go unrecognized until----well, until now.
15 years ago

if I understand indexes correctly (which I may not

I think S&P is right. Here is another way of thinking about this. You could create a "market-weighted" "Alternate" S&P 500 Index just by totaling up the market values of the 500 companies. Clearly, the "Alternate" Index value would then be in the many billions of dollars. Still, it would be functionally identical to the current market-cap weighted S&P 500, it just would be a heck of a lot bigger number, and it wouldn't use the divisor (the divisor keeps the current Index value related to its base value.....similar to the way the CPI is calculated). The question then would be, how would you want to compute earnings? Well, you would simply total up all the 500 companies earnings. Which makes a lot of sense. Then, you compare the value of the "Alternate" Index to its actual earnings. This is exactly what S&P has been doing....it's just that they've chopped the "Alternate" Index down to size, by using the divisor. Don't let the use of the divisor get in the way of thinking about this issue! OK, guys, tell me where I'm wrong......
15 years ago

Blitzer and Siegel are both Wrong

Blitzer is obviously wrong since the S&P 500 is market cap weighted. A portfolio that would mimic the S&P 500 would contain many more shares of XOM than JNY since XOM's market cap is more than 1000 times that of JNY.Siegel is wrong, since, as another poster pointed out, the earnings figures were reported using this flawed methodology since the beginning. Unless he has the earnings figures calculated using his methodology he has nothing to compare his figures.
15 years ago

I cannot believe it

The logic that S&P applies is rather absurd. The usual reason one would be calculating the earnings of the companies in the S&P 500 is to see how a portfolio, mirroring the S&P500 will perform. Since the S&P 500 is weighted by market cap, so should be the earnings. A simple example: In an index of 2 companies, company A with market capitalization of $90 earns $20 (or about $0.22 a share, assuming 100 shares), company B with market capitalization of $10 earns $0 (or $0.00 a share, assuming 100 shares). According to the S&P the earnings will be $0.11 a share ($0.22 earnings / 2 companies), while according to Siegel the earnings will be $0.20 a share (i.e. ($0.22*90 + $0.00*10)/100). If you have a dollar invested in a portfolio mirroring the index, the earnings number that makes sense is $0.20, i.e. 20% return on the invested dollar. Even the argument about treating the S&P companies as divisions of the same company does not make sense. In the example above if the two companies are treated as divisions, this still amounts to $20 earned on $100 invested, for a return of %20. Glenn Wessel is also correct about a potential loss limited to the equity amount, which is another reason why S&P's logic is flawed. For example Citi and GM can no longer impact negatively any S&P500 index fund out there. For all practical purposes the equity holders already lost it all and any loss from now on will be felt only by the debtors.
[email protected] 15 years ago

re: Historical PE figures

Has the methodology for calculating the S&P's PE ratio been the same over time? If we are comparing today's flawed figures with similarly flawed figures from the 1930's and 1970's bear markets, it might still provide something useful. Otherwise, it would be nice to see how the results would differ.
Glenn Wessel, CFA, CPA, CFP 15 years ago

Though I do not fashion myself as an expert as is "Herbilicious," I would say that S&P's methodology is flawed. Blitzer's example is flawed in one very important respect. If Jones Apparel were to lose $10 billion, the impact to shareholders would NOT be the same to shareholders. Since the market capitalization of Jones is only $.3 billion, the loss beyond shareholder equity (the remaining $9.7 billion) would have no shareholder impact. If Exxon were to lose that amount, its full impact would be felt. Siegal's arguement is more intellectually honest.
Herbilicious 15 years ago

As someone who has been referred to as an indexing expert and who wrote chapters in Fabozzi books on Global Index Families, I feel qualified to categorically state that Siegel is completely right and Blitzer is completely incorrect. The index is market-cap weighted. To do the earnings on an equally weighted basis distorts all the valuation ratios you need to use.