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Why Stocks Have Stunk Over the Past 10 Years

Pat Dorsey, CFA

Pat Dorsey: Hi. I'm Pat Dorsey, director of equity research at Morningstar. Happy holidays, though you may not be feeling quite so happy if you're looking at your financial statements from 1999 and comparing them to today, given that the past 10 years have been frankly pretty awful for the stock market.

And I'm sure you are going to read a lot of articles in the media, both financial media and otherwise, over the next few weeks talking about just that: what a terrible decade it has been for stocks and how, on an inflation-adjusted basis, you've actually lost money in stocks over the past decade.

And a lot of these articles are going to probably put a spin on this, thinking about, "My gosh. Why are people putting money in the stock market at all?" And you've got everybody putting lots of money into bond funds, which, of course, I talked about last week.

But I'll bet you that very, very few of these articles will talk about why the past decade was so terrible for stocks, and will make the point that past is not always prelude. Let's think about the past decade and why it was so terrible for the stock market.

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Well, there is a pretty simple reason. Just like in real estate, where you talk about the only three things that matter are location, location, and location, in investing, the only three things that matter are valuation, valuation, and valuation. And the price you pay for an asset has an unbelievably huge effect on the returns you will have after buying that asset.

So let's roll the clock back and see what people were buying if they bought the S&P 500 in 1999. I pulled up the top 10 stocks comprising about 25% of the S&P 500 in 1999. And you know, it's not a flaky bunch of companies. They're pretty solid. Microsoft, GE, Cisco, Wal-Mart, Intel.

There are a couple flaky names in there like Lucent and AOL, which haven't done so well over the past decade. But, you know, I don't think anybody would argue that Cisco was a good company then, still a good company now; Wal-Mart.

The problem was the prices that these companies were trading at. Listen to some of these price to earnings ratios. Microsoft at 72 times earnings. GE at 47. Wal-Mart at 57 times earnings. IBM was a bargain at 29 times earnings.

On average, you were paying 43 times earnings for the market in 1999. That was an enormous headwind on returns over the past decade. And that, more than anything else, is why stocks have stunk over the past 10 years, because your starting point was so high in terms of valuations that almost no degree of earnings growth could have overcome that enormously high level of expectations implied by 43 times earnings.

So, what are you buying today if you buy the stock market? Well, many of the same names are on that list. Top 10 stocks in the S&P 500 now: ExxonMobil, Microsoft, Apple, P&G, Johnson & Johnson, IBM, J.P. Morgan, GE. Stalwarts. Great businesses.

But listen to the way the valuations have changed. You're getting Apple for 25 times earnings; Microsoft at 20; ExxonMobil at 15; J&J at 14; IBM, J.P. Morgan, GE all at 14 times earnings. That is a big difference from 57 times earnings or this average of 43 times earnings that you were paying a decade ago.

And while I'm not going to argue that stocks are dirt cheap right now, you're not facing the headwind that you were in 1999 investing in equities today. Paying 14 times earnings for Johnson & Johnson or GE or J.P. Morgan Chase, it's not a dirt-cheap price, but it's a fair price. It's a reasonable price.

And if you think about the past decade as kind of like peddling uphill on a bicycle against this enormous weight of a high price-to-earnings ratio, well, you're probably not coasting downhill right now the way you were in, say, if you invested in March, but you are at least on a plateau. It's at least flat and you're not facing this enormous headwind, this enormous fight of high price-to-earnings ratios and high valuations.

So again, the point here is not that the market is dirt cheap right now. It's frankly not. But the point is simply that 2009 is not 1999, and don't read the past decade as prelude for the next one, because valuations are starting out for the next decade in a much better place than they were in 1999.

I'm Pat Dorsey. Thanks for watching. Happy holidays.