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Our Outlook for the Market

Even if the economy is not off to the races, we think the stock market can do well in 2012.

Heather Brilliant, CFA, 12/27/2011

--Surprisingly little has changed since last quarter, with uncertainty around the European Union's future continuing to depress stocks. We have seen only a modest improvement in valuations, as measured by the market-capitalization-weighted average price/fair-value of stocks under Morningstar coverage, which now stands at 85%, up from 78% at the end of the third quarter.

--Market volatility has been particularly pronounced throughout 2011, although for the last few months, news coming out of the U.S. has been largely irrelevant. With Europe dominating the headlines, U.S.-based companies have been whipsawed without regard to changes in underlying fundamentals. Despite a clear risk aversion among market participants, our price/fair-value data show large-cap stocks are most undervalued at 82% of fair value, compared with small-cap stocks trading at 88% of fair value.

--We expect economically sensitive sectors to outperform in 2012. While the timing of events such as a rebound in the U.S. housing market or employment market are particularly hard to call, the risk/reward in these cyclical sectors is increasingly in investors' favor. Many of the themes and trends we were seeing at the end of the third quarter still hold true today--namely, the market's laser-like focus on Europe; continued undervaluation in economically sensitive sectors such as industrials, basic materials, energy, and financial services; and reasonably strong numbers coming out of U.S. corporations.

We sense the beginnings of a shift under the surface, and we now have a decidedly optimistic outlook for the market in 2012. While the global economy will certainly continue to struggle for growth, well-positioned companies with little to no debt on their balance sheets should benefit from growing pockets of strength.

Last quarter, my colleague Erik Kobayashi-Solomon opined that we have a long way to go before we see the end of deleveraging, and I couldn't agree more. This is certainly a meaningful headwind when it comes to economic growth, and as our director of economic analysis Bob Johnson points out, this recovery will be a bumpy one with many fits and starts.

In fact, there's no shortage of bad news out there: Demand from China could falter. Austerity measures could sap any remaining consumer demand in Europe. The European Union could fail. These are all huge concerns, and stack up to a lot of good reasons to be bearish. So why do we expect 2012 to witness a meaningful rally in the market?

First, we think pent-up demand for hard goods is starting to take off in the U.S., as evidenced by strong growth in sales of cars and TVs in recent weeks, albeit at the expense of demand for services (See Bob Johnson's weekly commentaries for more details.) We have been commenting for more than a year that consumers cannot put off purchases such as cars and other hard goods indefinitely, and I think we all can agree that consumers cannot easily put off services like haircuts for long (at least we hope not!). While we're not calling for a huge return to growth in services, we think demand for hard goods will continue to benefit the U.S. economy.

Second, as my colleague Erik Kobayashi-Solomon commented last quarter, low leverage and strong profits leave U.S. corporations in an enviable position. In fact, U.S. company balance sheets are flush with a record $2 trillion-plus in cash, and profit margins are at or near all-time highs. Couple that with the undemanding multiples for investing in these firms lately, with the price/earnings ratio of the S&P 500 hovering around 13 times 2011 earnings, and we see some great opportunities out there. So even if the economy is not off to the races, we think the stock market can do well in 2012.

Heather Brilliant, CFA, is the vice president of Global Equity and Credit Research at Morningstar.

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