In an Op-Ed in this morning's Wall Street Journal, Jeremy Siegel argued that the earnings for the S&P 500 are understating actual earnings. While his entire argument can be read here, his basic premise is that Standard and Poor's calculates earnings based on each company's total earnings without taking into account their weight in the index. Siegal goes on to say that earnings should instead be calculated using each company's earnings times its weight.
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).
We'll let readers decide for themselves which approach makes more sense, but before making your decision, think about the result if the returns on the two investment were reversed and the $1,000 investment had a $100 loss while the $100 investment earned $100. According to S&P methodology, your total earnings would still be $0, but under Siegel's method, you would have a total loss of $90.