Bubbling to Dow 10,000

By Jon Birger

It has been four years since the Dow Jones industrial average first reached 10,000. Imagine that--only four years since investors convinced themselves that what went up wouldn't come down, that earnings did not really matter and that every budding technology company was a Microsoft in the making.

Can anybody say "deja vu?"

The closer the Dow gets to making a new assault on 10,000, the quicker investors seem to be unlearning all the lessons from the three-year bloodbath that preceded this year's rally. Morgan Stanley market guru Steve Galbraith grumbles that either the generations have become shorter or investor behavior deemed "once in a generation" has managed to repeat itself twice in four years. "Our biggest fear," he cautions, "is that the lunatic fringe is again engaging in behavior eerily reminiscent of the bubble."

The problem, as Galbraith sees it, is not that the economy isn't improving or that corporate earnings aren't bouncing back. They are. It's that too many investors have been afflicted by a perplexing bout of short-term-memory loss.

Consider what's happening in the technology sector, where investors are back to fawning over stock-option profligates like Cisco (up 54% year to date) and are even giving a second look to infamous Frank Quattrone IPOs like Corvis (up 91%) and Gemplus (up 88%). Overall, tech is once again the S&P 500's best-performing segment, rising 59% this year, even though that segment has experienced a 5% decline in the previous 12 months of earnings. This remains an industry dogged by sluggish corporate spending and huge amounts of excess capacity. So it's hard to comprehend why the stock market is valuing a dollar of tech earnings three times as highly as a dollar of earnings from nontech.

Another unwelcome blast from the past is the market's fascination with profitless wonders. Trading volume on the OTC Bulletin Board--purgatory for flimsy companies that no longer meet the major exchanges' listing requirements--exceeds the volume on the New York Stock Exchange. The last time that happened: 1999.

Money-losing firms in the S&P are once again outperforming their moneymaking peers, up 65% vs. 26% so far this year. Fiber-optic-components maker JDS Uniphase, for instance has not turned a profit since 1996, although it did help devastate many a retirement account. Yet shares of JDS have climbed 54% this year.

Investor boldness is rising too, a bad sign. Measured by the Chicago Board Options Exchange's Market Volatility Index, otherwise known as the VIX, the investing public is less fearful now than at virtually any other point over the past five years. Recently, the VIX stood at 16, down from 50 when the rally began in October 2002. The last time investors were this fearless was in August 2000. And margin loans--the OxyContin of day-trading junkies--are up 16% this year.

Looking for a silver lining? Here it is: with so much speculative money pouring into tech and penny stocks, a real buying opportunity exists in the large-cap, quality names that most of us should be buying anyway. Large companies with low debt, above-average dividends, good profit margins and a 10-year record of annual double-digit earnings growth are trading at a 22% discount to their historical price-to-earnings ratios. These stocks include oil company ConocoPhillips and pharmaceutical giant Pfizer.

Even a bear like Merrill Lynch strategist Richard Bernstein sees value in these tried and true names. "With all the problems we've seen over the past couple years, you'd think people would have rushed to higher-quality companies and bid their valuations through the roof. But it never happened," Bernstein says. "They're still buying tech." And they may be crying again soon if they don't add more blue chips to their portfolios.

You can e-mail Jon, a Money senior writer, at jon_birger@moneymail.com