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Our Outlook for the Market

As the market struggles under clouds of uncertainty, 10 out of 11 sectors are now trading at levels that we consider undervalued or cheap.

Erik Kobayashi-Solomon, 09/27/2011

  • Uncertainty regarding the viability of the European Union brought about by sovereign debt crises there has lowered the aggregate value of the U.S. market vis-à-vis Morningstar's fair value estimates. At the close of the third quarter of 2011, the market-capitalization-weighted average price/fair-value ratio of stocks under Morningstar coverage stands at an undervalued 78%.
  • The cheapest sectors consist of the usual suspects--the economically sensitive financial services, energy, industrials, and basic materials sectors--where some attractive businesses are selling at a substantial discount.
  • We believe uncertainty and equity market volatility will continue into the fourth quarter as European states struggle to balance the economic imperatives of their polities with their commitment to currency union. If uncertainty regarding the viability of the European Union deepens or if a determined and credible solution to the eurozone's structural weaknesses is not found soon, the impacts to global trade will likely be material over the short- to medium-term.
  • Companies in the U.S. are generally well-positioned to survive a downturn, having greatly improved the condition of their balance sheets and taken steps to increase profitability since the 2008-2009 downturn.

What a difference a quarter makes! In contrast to a fully valued market at the end of the second quarter, as we near Sept. 30, 10 out of 11 sectors are trading at price/fair-value ratios that we consider undervalued or cheap. Only consumer defensive stocks (where our team especially likes Avon AVP and PepsiCo PEP) are trading at a fully valued average price/fair-value ratio of 96%. Overall, stocks under Morningstar coverage are trading at a cheap 78%, though on an uncertainty-weighted basis, that ratio is slightly higher, implying an average star rating of closer to 4--undervalued but just shy of a Consider Buy price.

Investors looking for bargains and willing to tolerate some volatility should look to financial services, energy, industrials, and basic materials sectors, all of which are trading at price/fair-value ratios of less than 80%. A few of our teams' top picks in these sectors are Transocean RIG, ArcelorMittal MT, and Ford F. Please refer to the detailed sector reports for more specifics.

For more risk-averse investors, the market turmoil has brought defensive-oriented health-care names within reach of those searching for value. Our top picks in health care include Medtronic MDT, Abbott Labs ABT, and Covidien COV. Please see Thursday's sector outlook report for health care for more details about these companies and their operating environment.

The Macro Backdrop
In our last quarterly update in June, we raised the possibility of a period of "inflationary deflation" and indeed, several of our teams have reported this phenomenon to a greater or lesser extent. The inflationary part of the equation could be seen in rising prices in everything from agricultural commodities (due to such factors as Russian wheat shortages and interruptions to cocoa production) to luxury goods (as premium brands realized their market would bear higher selling prices) to manufactured goods (thanks to wage pressures in China). At the same time, persistently high un- and underemployment in the U.S. has contributed to slower personal income growth and a tendency toward wage deflation. After showing some signs of life early on in the quarter, housing prices as tracked by the S&P Case-Shiller Index have started moving down again, reinforcing the deflationary side of the trend.

The biggest macroeconomic stories of the third quarter had large political components. As we predicted in our last quarterly update, the European debt and fiscal crises have continued and deepened over the past three months to the extent that more and more observers are beginning to openly question the political viability of the European Union. The Greeks long for the ability to devalue their way to export prosperity that an independent Drachma would grant them while chafing at EU-imposed austerity measures; German voters grumble about picking up the tab for Greek profligacy. Readers who took our advice at the end of last quarter and shifted exposure in the financial sector from money center banks into regional ones spectacularly outperformed. As we had thought, regional banks have much less exposure to European debt issues than do money center banks and correspondingly did comparably better the more that Europe melted down.

In the U.S., what had long been considered a procedural matter of voting an increase in the debt ceiling limit to fund spending already approved by Congress turned into a full-blown political battle. The showdown ended up nearly halting government services and prompted the first agency downgrade of U.S. sovereign debt in history. The ugly political wrangling, combined with high levels of unemployment and an overall tepid recovery contributed to a drop in consumer confidence to 2009 crisis levels and set the ball rolling on what is feeling more and more like an equity bear market.

The one bright spot amid the gloom and concern has been falling energy prices. Morningstar director of economic analysis Robert Johnson notes that gasoline prices have fallen for three consecutive months. We had predicted this occurrence in our previous quarterly update on the theory that tensions in the Arab world during the spring would wilt under the hot summer sun. This was perhaps the impetus, but the trend has been exacerbated recently by uncertainty in Europe and weakening economic readings in the U.S. prompting concerns of a global slowdown. Whatever the reason, lowered prices at the pump have indeed allowed less affluent shoppers to benefit from the fuel tax "rebate" and keep up with steady 3%-5% per annum growth in spending--a dynamic that we predicted last June.

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