Our Terms of Service and Privacy Policy have changed.

By continuing to use this site, you are agreeing to the new Privacy Policy and Terms of Service.

The price you pay for frothy assets

By Pat Dorsey, director of equity research for Morningstar


(Money Magazine) -- As the 10th anniversary of the bursting of the tech bubble is upon us, you've probably read a slew of stories about what an awful decade this has been for stocks.

But what drives me nuts is that despite all this press, there's still very little discussion about why stocks have stunk since the market crashed in March 2000.

pat_dorsey_2009a.03.jpg
Pat Dorsey is the director of equity research for Morningstar.
CDs & Money Market
MMA 0.30%
$10K MMA 0.28%
6 month CD 0.39%
1 yr CD 0.62%
5 yr CD 1.47%

Find personalized rates:
 

Rates provided by Bankrate.com.

The reason is simple: A decade ago most equities were insanely expensive. Even shares of boring blue-chip companies were trading at frothy price/earnings ratios of 40 or 50 -- a fact that sometimes is forgotten because so many of our memories of the go-go '90s center on profitless outfits like Pets.com.

Those frothy valuations turned out to be an enormous headwind to equity returns because they reflected sky-high expectations that only a ridiculous rate of earnings growth could have met.

A perfect example is Wal-Mart (WMT, Fortune 500). In 2000 the world's biggest retailer traded at a P/E of 42.5, which is steep for such a mature firm. That year the company earned $1.25 a share. Multiply that by the P/E, and you get a share price of around $53.

Over the past decade Wal-Mart's earnings have nearly tripled, to $3.41 a share, a solid annual growth rate of 12% (that's just a tad lower than the company's 14% growth rate in the mid- to late '90s).

But because profit expectations were set so high, investors wound up punishing Wal-Mart by cutting its P/E at about the same pace that the firm's earnings expanded. As a result, Wal-Mart's stock price has pretty much gone nowhere even though the company has delivered solid results.

This is the tyranny of valuation in its simplest form. Nothing affects your future returns more than the price you pay for your investments.

Forgetting the past

I want to drive this point home because investors appear to be making the same mistake today -- only with a different investment.

Consider this: In 1999, Americans shoveled nearly $200 billion into equity funds when stocks traded at 40 times earnings. At the same time, they yanked $4 billion out of bond funds when 10-year Treasuries were yielding around 6%.

Today it's just the opposite. Investors pulled about $4 billion out of stock funds over the past year even as P/Es fell to 20 (that's not cheap on an absolute basis, but it's a better deal relative to a decade ago). Meanwhile, they poured around $300 billion into bond funds after demand for Treasuries had grown so much that yields fell to less than 4%.

Now, I can't say whether the next decade will be as bad for stocks -- or as good for bonds -- as the past 10 years were. But I do know the tradeoff today between equities and fixed-income investments is very different than it was in March 2000.

For instance, because investors aren't paying record prices for stocks anymore, profit expectations won't be nearly as high as they were a decade ago. However, because you're paying frothier prices for government bonds, the bar will be set higher for Uncle Sam's financial performance. So ask yourself how confident you are in the government's balance sheet.  To top of page

Overnight Avg Rate Latest Change Last Week
30 yr fixed3.93%4.14%
15 yr fixed3.03%3.14%
5/1 ARM3.32%3.28%
30 yr refi4.02%4.21%
15 yr refi3.11%3.21%
Rate data provided
by Bankrate.com
View rates in your area
 
Find personalized rates:
Index Last Change % Change
Dow 17,745.98 -5.41 -0.03%
Nasdaq 5,128.79 17.06 0.33%
S&P 500 2,108.63 0.06 0.00%
Treasuries 2.27 -0.01 -0.48%
Data as of 9:34pm ET
Company Price Change % Change
Facebook Inc 95.21 -1.78 -1.84%
Bank of America Corp... 18.13 -0.03 -0.17%
Microsoft Corp 46.88 0.59 1.27%
Whole Foods Market I... 36.08 -4.74 -11.61%
Ford Motor Co 15.10 -0.11 -0.72%
Data as of 4:01pm ET

Sections

Loosening state restrictions have given gun silencer sales a boost. Silencers are now legal in 41 states, compared to 37 four years ago. Also some gun makers are making it easy to attach them. More

Pinterest reveals its diversity numbers and announces how it plans to diversify its workforce. More

Fast-food chains that operate in more than 30 locations nationwide are the sole target of a new rule in New York to hike their minimum wage to $15. But consumers and small business owners, as well as some employees, may be the ones to pay the price. More

You can't blame it on the economy anymore. More Millennials now have jobs, but are still living at home. More