February 26, 2009
Sir:
In his Feb. 25 op-ed, Professor Siegel claims that S&P systematically understates the earnings of the S&P 500. In his view, the recent losses of the financial companies in the S&P 500 should be discounted because of their diminished weights in the Index.
His argument, however, fails the simple tests of both logic and index mathematics. 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.
Professor Siegel’s example of Exxon-Mobil illustrates why S&P’s method of calculating earnings works. If large Exxon-Mobil earned $10 billion and small Jones Apparel lost $10 billion, index investors collectively — and individually – would bear a proportionate share of both Exxon’s earnings and Jones’ loss, despite the fact that the value of Exxon-Mobil’s shares in the index portfolio is about 1,381 times the value of the Jones’ shares.
To use an analogy, we could hypothetically view the S&P 500 as a single company with 500 divisions, with each division having earnings and an implicit market value. The smallest of these divisions could have an outsized loss that wipes out the combined earnings of the entire company. Claiming that these losses should be ignored or minimized because they came from a less valuable division is flawed.
Professor Siegel’s approach — applying the weights based on market values to the results based on a company’s earnings — effectively mixes apples and oranges.
Sincerely,
David M. Blitzer
via http://www2.standardandpoors.com/spf/pdf/index/030209_Siegel-Response-Letter.pdf

That is the clearest rebut of Siegel I have read.

Sector Rotation

I have been investigating sector based investing over the last few months and have yet to be convinced there is any actionable merit in it. However, if you look at a snapshot of the S&P500 results year and month to date it does appear to confirm the thesis I have been working on. Yeah I know one sample does not make a compelling case, but it does support what the proponents of sector rotation and big picture  logic predict.

Coming out of a recession the leaders are likely to be materials, consumer discretionary and information technology. I’ve ignored Financials as they are a special case this time. Though I do find it interesting that some pundits say whatever led us down will lead on the way up, while others like Jim Rogers say financials are not going to recover for five to seven years. Sectors that logic and sector rotation believers suggest will lag include consumer staples, health care and utilities. Now you may think I’ve simply picked the three best and three worst sectors to illustrate my point, but if you think about it for a few minutes and look at any sector rotation theory you’ll see both the logic and that I have not cherry picked the data. There is one exception, industrials. They are expected to outperform early in the recovery, while they are showing slight out-performance my issue with that group is its diversity. 

Consumer discretionary leads as they hit their cyclical bottom in the recession and are one of the first to pull out as consumers start to spend again. Materials are at the start of the supply chain so they naturally lead and information tech leads as the pent up discretionary demand of business and consumers begins to unwind. Consumer staples, health care and utilities are all defensive and present the least value to investors coming out of the recession. I have been surprised by how many intelligent people have been pushing PG of late. While they may be  right that PG is good absolute value it is not good relative value and the return to risk is much better in cyclical names this close to the end of a recession.     

While I do not subscribe to sector rotation as a primary tool to manage my portfolio it does make logical, big picture sense to me. I do consider sector when looking for opportunities.

I posted the following graph of Consumer Discretionary past and future earnings back in December. It graphically illustrates why sector rotation is worth considering. If I get time later I’ll add a comparison to consumer staple. [I now done it. Click here for the comparision plus a couple more charts on S&P500 earnings. ] 

Just the facts Jack, just the facts.

I’m kidding of course. There is no such thing as facts when it comes to topics like sector rotation, there are merely views. Here are the for and against cases.

• Academic papers exist which cast doubt on sector rotation. I linked this one before on Sector Rotation over Business-Cycles. 
• Conversely papers such as this one on Sector Rotation and Monetary Conditions present a compelling argument for sector rotation.

One final tool. Stockcharts interactive performance comparision chart is a great tool for a quick snapshot of sectors. As you’d expect it shows consumer staples, healthcare and utilities have been the places to be over the last year. That alone should make anyone considering new investments in those sector pause and reflect.

Related posts:

1. S&P500 Earnings Update and Sector Focus
2. S&P 500 Sector Earnings
3. S&P/ASX 200 Sector Performance Since Cycle Lows
4. Klarman’s Wisdom and Sector Rotation
5. S&P/ASX 200 Buring up for your lovin’
6. Riding the Wild Equity Roller Coaster