In and out of the S&P 500

[erik_kosberg]

Today’s Financial Sense Market WrapUp makes an interesting point about the seven companies removed from the S&P versus the seven added to it:

Many of the companies removed were natural resource companies such as Royal Dutch Petroleum, Barrick Gold and Placer Dome. The changes will sharply reduce the representation of gold stocks in the S&P 500, removing two of the three gold stocks in the index. The only gold stock left is Newmont. The removal of Royal Dutch also reduces the representation of oil in the index. Deleting these companies removes some the best performing companies within the index and replaces them with financial companies. The S&P committee did not apply the same logic to the 10 companies in the index that are based out of the Bahamas such as Tyco International or Carnival which is based in Panama.

One has to wonder about the wisdom of such an approach, especially at a time when gold shares have been outperforming the major indexes over the last two years, a time when the CRB index of commodities is moving to new highs, the price of oil is rising along with gold and silver you have the removal of commodity based companies from the index. You also have mutual fund companies like Vanguard closing down its gold fund to new shareholders and Fidelity selling off shares of gold companies.

The companies that are replacing the natural resource companies are Goldman Sachs, Ebay, UPS, Prudential Financial, Principal Financial Group, SunGard Data Systems Inc., and Electronic Arts. One can only imagine what this will do for the real P/E ratio of the S&P 500. Ebay sells at 140 times earnings, Electronic Arts trades at 90 times earnings, and UPS trades at a multiple of 30.

S&P hopes the changes will generate some more buying power for the S&P with nearly $1 trillion in index funds and many more funds acting as closet index funds. It is almost as if the financial industry wants to generate an artificial rally. If the indexes don’t rally on their own, perhaps reengineering the index will help. Let's not forget that P/E multiples computed for the S&P 500 are also artificial since they aren’t computed on the net income figures of the companies. The P/E multiple is now based on a variation of pro forma earnings. Why stop with that? Maybe in the future we will see pro forma prices calculated by a computer in much the same way that the value of OTC derivatives are computed. We now have pro forma earnings, pro forma economic numbers, and pro forma media reporting. Why not have pro forma prices as well? We already live in a land of make believe. Why not carry it to its full conclusion? We could turn the financial markets into an investor theme park of make believe in much the same way as Disneyland. Come to think of it, this may be much easier done than originally thought since Disney owns ABC and GE owns CNBC.