By Jeremy Seigel, PhD – Russell E. Palmer Professor of Finance at the Wharton

On February 25 I published an op-ed piece in the ‘Wall Street Journal‘ entitled, “The S&P Gets Its Earnings Wrong.” In that article I said that, although the S&P weights each individual’s stock by its market capitalization to compute the return on the S&P 500 Index, no such methodology is used to compute aggregate earnings of the index.

As a result, the billions of dollars of losses racked up by, say, AIG, whose market value is extremely low, is added dollar for dollar to the earnings of the profitable firms, such as Exxon Mobil, whose market value is more than 20 times larger. I maintained that S&P’s methodology gave far too much influence to firms with big losses and low market values, and thereby gave a distorted valuation to the S&P 500 Index.

A Challenge to Standard& Poor’s

I proposed an alternative methodology for computing aggregate earnings: Weight the earnings of each company by its current market value, in a fashion identical to the way the return on the S&P 500 Index is computed. This alternative methodology leads to substantially higher earnings for the index than does the S&P methodology.

According to Standard& Poor’s, total reported earnings on the S&P 500 index for calendar year 2008 was a mere $14.97, the lowest in many decades, primarily because of the huge losses of a few financial firms. S&P reports that, at the index’s level on March 31 of 798, the S&P was selling at an extraordinarily expensive 53.3 times last year’s earnings.

Yet S&P’s own Web site says that “AIG’s record setting Q4 ‘08 ‘As Reported’ loss of $61.7 billion, or $22.95 per share, took $7.10 off the index.” AIG’s quarterly loss was so massive that it more than canceled out the entire year’s income of Exxon Mobil, which earned $45 billion in 2008. For the full year, AIG lost over $99 billion, more than twice the total profits of Exxon Mobil.

Where the Distortion Comes In

Here is where the distortion comes in. Exxon Mobil has a market value of $350 billion, while AIG’s value is now a mere $15 billion (and it was only $5 billion a month ago). That means that the average investor owns more than 20 times as much Exxon Mobil stock in their portfolio as AIG stock, so that for the average portfolio of those two stocks, the oil…
continue reading