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What's the Market Really Worth?

An update on the valuations of major indexes.

Sonya Morris, 10/16/2007

One way to get a read on the general attractiveness of stocks is to examine the valuations of major market indexes. To do so, we can tap into the work of Morningstar's 100-plus equity analysts.

With more than 2,000 stocks under coverage, our research spans much of the market. We cover all of the stocks included in the Dow Jones Industrial Average, and almost 98% of the assets in the S&P 500 Index. Thus, we can compute meaningful aggregate fair values of those familiar market barometers. Then we can compare the indexes' aggregate fair values with their current market values to gauge whether or not the market, as defined by those benchmarks, is cheap or dear.

The Dow's discount to fair value is about where it was at the close of the second quarter when we last visited this topic. But the S&P 500 looks cheaper than it did three months ago. Still, the market can't be considered dramatically undervalued. Third-quarter volatility did bring a few more bargains to light, but value-priced stocks aren't plentiful across the board.

 Market Index Valuations

Index Value

Fair Value Estimate
% Under- or Overvalued
Dow Jones Ind. Average
14,066.01
14,963.84
-6.4%
S&P 500
1,557.59
1,622.49
-4.2%

Data as of 10-05-07

A look at the most attractive Dow stocks gives some clues as to where the most compelling bargains can be found. Here's a list of the Dow components that have earned 4- and 5-star ratings.

  Dow Components with Recent 4- or 5-Star Morningstar Ratings
Company
Fair Value
Estimate
Market Price
Moat
Rating
Risk
Rating

Morningstar
Rating

Home Depot HD
$44
$34.22
Wide
Below Average
Alcoa AA
$52
$38.79
Narrow
Average
Wal-Mart Stores WMT
$60
$45.37
Wide

Below Average

J.P. Morgan Chase JPM
$63
$47.58
Wide
Average
Citigroup C
$64
$48.30
Wide
 Average
Johnson & Johnson JNJ
$80
$66.25
Wide
Below Average
Pfizer PFE
$31
$25.58
Wide
Average
Microsoft MSFT
$34
$29.84
Wide
Below Average
Walt Disney Co DIS
$40
$35.47
Wide
Below Average
American Express Co AXP
$70
$61.10
Wide
 Below Average
American Intl Group AIG
$80
$69.39
Narrow
Average
Boeing BA
$122
$102.25
Narrow
Average

Data as of 10-05-07

Financials
Notice that four financial firms are included on this list: J.P. Morgan JPM, Citigroup C, American Express AXP, and American International Group AIG. The subprime mortgage mess that weighed on stocks this summer hit the financials sector particularly hard. But a number of high-quality financial firms were taken down in the sell-off, and many of these companies have only minimal exposure to subprime loans. That offers an opportunity for long-term investors to scoop up some financially sound, competitively well-positioned businesses at bargain prices.PAGEBREAK

ETFs offer a way to gain diversified exposure to the sector, and several financial ETFs boast compelling valuation characteristics. For example, iShares Dow Jones US Financial Services IYG is trading at roughly a 16% discount to its aggregate fair value and Financial Select Sector SPDR XLF is trading at a 12% discount. For a more targeted play on bank stocks, consider KBW Bank ETF KBE.

Granted, the financials sector still faces some near-term challenges, as evidenced by recent news of charge-offs taken by major banks like Citigroup and Deutsche Bank DB. But for patient long-term investors, the valuations among financial stocks are quite intriguing.

Consumer
Wal-Mart WMT and Home Depot HD both have been in 5-star territory for several months, but they got even cheaper during the third quarter, as investors grew concerned that the subprime mess would cast a pall over the broader economy. But the bargains in the sector go well beyond these two Dow components. For example, many other high-quality retail stocks look cheap. Bed Bath & Beyond BBBY and Staples SPLS rank among our favorites.

ETFs that focus on the retail sector look cheap. SPDR S&P Retail XRT and Retail HOLDRs RTH boast price/fair value ratios of 0.88 and 0.86, respectively. (PowerShares Dynamic Retail PMR isn't quite as cheap with a ratio of 0.95.) However, it's important to note that these two ETFs are very different despite their similar names. SPDR S&P Retail provides exposure to midsize retailers like Gamestop Corp. GME, a video game retailer, Guitar Center GTRC, and casual apparel maker Guess? GES. However, Retail HOLDRs focuses more on industry leaders like Wal-Mart, Target TGT, and Amazon.com AMZN.

Several broadly diversified consumer ETFs have price/fair value ratios of 0.90 or below, including Consumer Staples Select Sector SPDR XLP, which is dominated by leading consumer firms that are trading at compelling valuations, such as Wal-Mart, Costco Wholesale COST, and Walgreen WAG.

Sonya Morris a fund analsyt with Morningstar.

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