"S&P is lousy at make-or-break bingo"

So reads the headline on a recent (7/23/03) column by Contributing Editor Jon D. Markman on MSN Money. Mr. Markman's "Super Models" column is an interesting exercise in stock picking. His book "Online Investing" is, I think, the best guide to online investing tools written to date.

I wish, however, that he'd develop a sense of proportion and history about the S&P 500 Index and how it functions. A little over a year ago he started attacking the Index as "mis-managed." He continues to attack the index and its creator, Standard and Poor's, today.

The result is a lot of nervous Couch Potato investors--- and that upsets me.

The problem in the recent column is that Mr. Markman fails to provide any sense of scale. He attacks Standard & Poor's as "consistently ham-fisted, as in its recent handling of make-or-break moments for electric utility Mirant and American Airlines, parent AMR Corp."

How ham-fisted?

About 670 percent worth, by his measure. That's the rise in AMR stock from March 13 when S&P dropped it from the index at $1.40 a share. Since then the stock has soared to nearly $11 a share. Over the same period, he points out, "the next best move" among S&P 500 stocks was "Avaya, at about 225 percent."

That sounds pretty awful, doesn't it?

In fact, these changes had virtually no impact on the S&P 500 Index or its performance, a fact Mr. Markman failed to consider or mention.

You can understand by following me through a little exercise in proportion. On March 13, at $1.40 a share, AMR was worth about $222 million. On July 23, at a closing price of $10.29 a share, AMR was worth $1,634 million, an increase of $1.412 billion.

While that would be a lot of money if we found it in our checking account, it's a small amount measured against the market value of the nations' largest and most valuable companies. General Electric, for instance, ranks number one on the S&P 500 list. The total market value of GE is a massive $286.6 billion. It accounts for 3.19 percent of the entire value of the $9 trillion index.

So let's do the math.

The entire increase in market value for AMR amounts to just less than  ½ of 1 percent of General Electric. Do the same calculation for the total market capitalization of the S&P 500 index itself and that ham-fisted omission amounts to 0.000157 of the index. Expressed as a percent, that means the entire AMR appreciation is somewhere between 1/100th of 1 percent and 2/100ths of 1 percent of the index. That's pretty thin slicing.

Similarly, he chides the S&P 500 management crew for failing to drop Mirant, an electric utility, from the index and taking it on a "fast ride to zero." Again, a sense of proportion is in order. Although it sold at $2.28 a share on July 10 when a Merrill Lynch analyst published a report saying the odds of an out of court debt restructuring (bankruptcy) were less than 50 percent, S&P dropped the stock from the index on July 16 at a value of zip.

According to the Morningstar stock database, Mirant had 404 million shares outstanding at the end of June so that fast ride to zero was a loss of about $901 million--- almost exactly 1/100 of 1 percent of the total value of the S&P 500 Index.

In theory, the folks at Standard and Poor's should have kept AMR in the index since it didn't go bankrupt, the event that triggered the Mirant removal. But in the big picture, both actions were to the far right of the decimal point. They will have no measurable effect on the index or its primary goal.

What is that goal?

The goal of the index is to reflect the performance of America's largest companies across a diversified set of industries. The goal of an index is NOT to be micro-managed by stock jockeys. It is to reflect the broad performance of an asset class.

S&P is lousy at make-or-break bingo by Jon D. Markman

Tuesday: More About Indexes