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 0.37%
$10K MMA 0.33%
6 month CD 0.35%
1 yr CD 0.67%
5 yr CD 1.38%

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

Frontline troops push for solar energy
The U.S. Marines are testing renewable energy technologies like solar to reduce costs and casualties associated with fossil fuels. Play
25 Best Places to find rich singles
Looking for Mr. or Ms. Moneybags? Hunt down the perfect mate in these wealthy cities, which are brimming with unattached professionals. More
Fun festivals: Twins to mustard to pirates!
You'll see double in Twinsburg, Ohio, and Ketchup lovers should beware in Middleton, WI. Here's some of the best and strangest town festivals. Play
Overnight Avg Rate Latest Change Last Week
30 yr fixed4.32%4.27%
15 yr fixed3.29%3.27%
5/1 ARM3.34%3.47%
30 yr refi4.29%4.24%
15 yr refi3.26%3.25%
Rate data provided
by Bankrate.com
View rates in your area
 
Find personalized rates:
Index Last Change % Change
Dow 16,960.57 -123.23 -0.72%
Nasdaq 4,449.56 -22.54 -0.50%
S&P 500 1,978.34 -9.64 -0.48%
Treasuries 2.47 -0.04 -1.59%
Data as of 2:52am ET
Company Price Change % Change
Facebook Inc 75.19 0.21 0.28%
Apple Inc 97.67 0.64 0.66%
Bank of America Corp... 15.59 -0.03 -0.19%
Ford Motor Co 17.62 -0.22 -1.23%
Applied Materials In... 21.23 -0.52 -2.41%
Data as of Jul 25

Sections

The food processing company accused of mishandling meat at its Shanghai, China plant says it will suspend sales and recall all food processed there. More

Is the economy back on track after a weak first quarter or about to get blown away? Investors will find out when the curtain is drawn on jobs and GDP data. There's also a Federal Reserve meeting. More

Louisiana is now the top location for motion picture filming, supporting thousands of new jobs and small businesses. More

Americans with disabilities face huge financial hurdles and it starts early on, according to a recent report. More

Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.