Jeremy Siegel, Wrong


No, the charming Wharton professor isn’t dead. But he may just have killed what’s left of his reputation.

Prof. Siegel, who wrote the 1990s classic Stocks For The Long Run and is now a pitchman for WisdomTree mutual funds, has been very bullish, and very wrong, for the past two years.  There’s no shame in that–most people have been wrong.

Unlike other bludgeoned bulls, however, Prof. Siegel has stuck to his guns, arguing in ever-more-creative ways that stocks are screamingly undervalued.

For example, in November last year, when most of his academic brethren agreed that fair value for the S&P 500 was about 900-1000, Prof. Siegel argued that the index was actually worth 1,350 (See “Prof. Seigel’s Strange Claim: Stocks Are Dirt Cheap“) 

When Prof. Siegel defended this conclusion against an onslaught of criticism (including ours), his defence invoked the argument that has doomed faith-based investors since the dawn of markets: It’s different this time.  (See: Jeremy Siegel Fights Back: You’re All Wrong, Stocks ARE Dirt Cheap)

And today, Prof. Siegel returns with an argument that is not just wishful thinking, but flat-out silly.

In a WSJ op ed, Prof. Siegel argues that S&P 500 earnings are misleading because they aren’t market-cap weighted. The index is market-cap weighted, Prof. Siegel says, so earnings should be, too.  In other words, when penny-stock Citigroup loses $20 billion, the S&P 500 earnings should only be docked a small amount, because Citigroup has such a small market cap.

Come again?

As one of our readers explained, here’s how the S&P 500 works:

  • % change in the price of the index = % change in the aggregated market capitalisation of all stocks in the index (yes, a simple unweighted sum of market caps)
  • % change in the “earnings” for the index = % change in the aggregated earnings of all stocks in the index (yes, a simple unweighted sum of earnings for each company)

In other words, the market-cap weighting doesn’t affect the market capitalisation of the entire index.  Similarly, the earnings of the small-cap companies in the index don’t–and shouldn’t–count for less than the big ones.

Prof. Siegel wants us to believe that this way of calculating earnings is somehow misleading:

As the fourth-quarter earnings season draws to a close, there are an estimated 80 companies in the S&P 500 with 2008 losses totaling about $240 billion. Under S&P’s methodology, these firms are subtracting more than $27 per share from index earnings although they represent only 6.4% of weight in the index. S&P’s unweighted methodology produces a dismal estimate of $39.73 for aggregate earnings last year.

If one applies market weights to each firm’s earnings using the same procedure that S&P employs to compute returns, the results yield a more accurate view of the current profit picture. Market weights produce a reported earnings estimate of $71.10 for 2008 — nearly 80% higher than the unweighted procedure. The reason for this stark difference is that the firms with huge losses generally have extremely low market values and hence have a much smaller impact on the total earnings in the index.

Translation: Ignore those massive losses in the financial sector because the market is placing a low value on those companies right now.

But those are real dollars those companies are losing.  They are real dollars whether the companies are worth $1 or $100 billion.  Add up all those dollars, plus and minus, and you get the total earnings of the S&P 500 (which may be negative in Q4 for the first time ever).

In this and his other “stocks are dirt cheap” analyses, Prof. Siegel appears to be making the same mistake many market participants make: Bending data to fit deeply held beliefs instead of letting data determine those beliefs.  This is understandable for rookies.  It’s not understandable for a professor.

Established and defensible methods of valuation, such as the cyclically adjusted PE developed by Prof. Siegel’s friend Professor Robert Shiller, suggest that the S&P 500 is now moderately cheap.  But the market is almost certainly not, as Prof. Siegel contends, “much cheaper than is currently being reported by S&P.”

Bespoke attacks Prof. Siegel’s argument here.

While the argument may sound convincing, it doesn’t really make sense.  The S&P 500 is meant to represent the total value of the 500 largest companies in the US based on market cap.  While a $10 million increase in a company’s market cap will have a bigger impact on the stock price of Jones Apparel, which is the smallest company in the index, than it will on ExxonMobil, which is the largest company in the index, the impact on the index is the same.  If the prices of all other 499 stocks remain the same, a $10 million increase in market cap for any one company has the same impact on the index regardless of the company’s size.  

Now let’s apply this logic to earnings.  Imagine you have two investments.  The first is worth $1,000, and over the last year it generated $100 in income.  The second investment is only worth $100, but over the last year, it had a loss of $100.  Most people would probably think of their investments in the way S&P calculates the earnings for the S&P 500.  You would have total investments of $1,100 ($1,000+$100) and earnings of zero ($100 profit on $1,000 investment plus $100 loss on $100 investment).  Using Siegel’s logic, however, your total earnings would be much better (although you would be living in la la land).  Since your $100 investment is only worth one tenth of the value of the $1,000 investment, the loss from that investment would only be a tenth as much.  In this case, your total earnings would be $90, as the $100 loss would only be worth $10 ($100 + $10 loss = $90).

Felix Salmon shreds it here:

Jeremy Siegel has an absolutely astonishing argument in the WSJ today, designed to prove that stocks are quite cheap really: he says that S&P “miscalculates” the earnings of the S&P 500, for the purpose of calculating the index’s p/e ratio…

Earnings don’t change according to market capitalisation. The p/e ratio is an interesting animal: the numerator changes from day to day and even from second to second, while the denominator changes only once a quarter. It’s an indicator of how the market (the numerator) is reacting to reality (the denominator). But under Siegel’s method, the denominator changes every second as well.

Paul Kedrosky here:

This is a permabull program for  emphasising good times and de-emphasising bad times. It is always tilting toward making things appear cheap after the fact when stocks have declined/advanced (ex post), rather than being an accurate measure of the overall health of the companies in the index as constituted (ex ante).

To be marginally more charitable, at the very least Siegel should have recalculated the series over history to show what his new cap-weighted earnings multiple would look like. Trotting out a single adjusted figure with no context of what cheap now means in S&P 2.0 Siegel-world is meaningless.