How The Financials Are Greatly Masking the Market’s Earnings Potential

Some people are making the case that the stock market can rally meaningfully even without the financial sector recovering. I disagree simply because earnings are being negatively impacted so severely by loan losses and mark to market writedowns at the large financial institutions that investors won’t get a clear picture of what a reasonable expectation for S&P 500 earnings are until financial sector earnings at least stabilize, if not climb back toward breakeven.

Jeremy Siegel, well known Wharton finance professor and author of “Stocks for the Long Run” (an excellent book) had an opinion-editorial piece in the Wall Street Journal recently that was titled “The S&P 500 Gets Its Earnings Wrong” (subscription only — get 2 free weeks here if you are not a WSJ online subscriber) that made some interesting points about the currently depressed level of earnings for the S&P 500.

Dr. Siegel explains that while the S&P 500 is market value weighted (larger companies are weighted more heavily in the index than the smaller ones), Standard and Poor’s does not use the same methodology when calculated the index’s earnings. Instead, a dollar of profit from the smallest stock is treated the same as a dollar earned by the largest. As a result, the losses being accumulated by a small portion of the index are negating the profits being generated by the majority, which is making the S&P 500’s earnings look overly depressed.

Consider the data below, taken from Siegel’s column:

Siegel is suggesting that the absolutely abysmal financial performance of the market’s worst stocks last year (mostly from financial services firms, of course) is giving the appearance that corporate profits have absolutely fallen off a cliff in every area during this recession. He is quick to point out that 84% of the largest 500 public companies in the U.S. (420 out of 500) are actually doing quite well. That fact is going unnoticed because $1 of earnings from the smallest stock in the S&P is treated the same as $1 of earnings from the largest component, even though an investor in the S&P 500 owns 1,300 times more of the largest one than the smallest.

I’m not sure if Siegel is suggesting that they should actaully go ahead and change the way they calculate S&P 500 earnings (and if so, I’m not sure I would even agree with him), but I do think this data is very helpful in seeing just how much the financial sector is masking corporate profits from other sectors.

My personal estimate right now for S&P 500 fair value is around 1,050 (14 to 15 times normalized earnings of between $70 and $80). I came up with those estimates before reading Siegel’s article, but the data he provided give me comfort in the estimate. After all, if you assume the bottom 80 companies get back to breakeven and the other 420 companies maintain their 2008 profitability (both are conservative assumptions when the recession ends in my view), we see that S&P 500 earnings would range from $67 (if you use GAAP earnings) to $81 (if you use operating profits)

As you can see, any relief for the financial sector with respect to mark-to-market accounting principles could temper the writedowns going forward. Even getting the financial sector to breakeven by 2010 would reduce the negative earnings impact from the bottom 6% of the S&P 500, clearing the way for earnings to rebound pretty quickly from the $40-$50 level analysts are projecting for 2009.

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3 Thoughts on “How The Financials Are Greatly Masking the Market’s Earnings Potential

  1. 2 points:

    1. I think you are overestimating normalized profit margins for the S&P 500 with a $70-80 expectation of “normal” earnings. Jeremy Grantham has made this point frequently. Margins are mean reverting, and they can’t stay above average indefinitely. Using average historical margins gets you to around $60-65 in S&P normal earnings. put a historically average 14-15x multiple on that and you get…~900, which is where GMO puts approximate fair value on the S&P at. Remember that 2008 profits for the economy as a whole, certainly for Q1-Q3 were still being juiced by massive leverage outside the financials also – this included commodities, industrials, utilities, transports, and most importantly – consumer cyclicals. I will fully admit that in the grand scheme of things, fair value of 900 or fair value of 1050 is not that big of a difference. But for the near term, if you expect the economy to generate below average profit margins for a long time due to deleveraging not just the financial sector (as opposed to a steady state level of leverage, which will allow us to get back to average profit margins) as I do, there is no rush to put your money to work.

    2. Siegel is being extraordinarily disingenuous with his analysis. Remember that S&P earnings have ALWAYS been calculated the way they are today. Given that valuation is an inherently comparative activity, you can’t compare the S&P valuation using Siegel’s method to the past because no one else ever used that method in the past. If you put together a time series of Siegel’s metric, you would probably come to a very different conclusion – that while the market is definitely undervalued, it’s not massively undervalued like Siegel has been arguing for a long time.

    A better way of realizing that Siegel’s argument holds little water is historical dividend yields for the index – there’s no way to manipulate that. It’s the cash that ends up in the investor’s pocket holding the market basket. By those standards as well, the market is moderately cheap (10-15% undervalued) but not incredibly undervalued.

  2. Chad Brand on March 20, 2009 at 12:14 PM said:

    I guess I am comfortable with a little higher earnings number than that because the recession began in December 2007, which obviously includes all of 2008. Given we were in recession including a huge 6% GDP drop in Q4, and yet still saw the S&P 500 earn $67 in operating earnings.

    I agree with your second point that using Siegel’s analysis to prove the market is undervalued is misplaced. I don’t think he was really making that point in the piece. His argument for the market being cheap (in other writings of his) centers around normalized earnings of $90 or something like that, which is too high for my taste. I am just using the numbers that he pointed out and they can’t really be manipulated since it’s straight math.

    I think the point here is more about the impact of the financials on earnings and not the valuation of the market. Hopefully we will see what normalized earnings wind up being in 2010 or 2011.

  3. The thesis is faulty in assuming 420 of the 500 companies are doing alright. If one believes this factoid, then people should buy stocks.

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