Our Outlook for the Stock Market

• We continue to view the market as pretty close to fairly valued, with stocks under Morningstar coverage trading at 92% of fair value in mid-December, using a market-capitalization-weighted average. This is not materially different than last quarter, when our coverage universe was trading at 91% of fair value.
• Market volatility will be a way of life in 2013, as Europe continues to work on solving its debt problems, China's growth remains closely scrutinized, and the U.S. grows in fits and starts. In this environment, we think stock-picking will make a comeback, and investors focusing on specific stock opportunities will do well given this backdrop.
• Despite the media's penchant for touting the fiscal cliff as a major crisis, we think it will end up being a non-event. It has to get resolved one way or another, whether politicians finally agree to reach a compromise, or the U.S. is forced into its own austerity. While the latter scenario may bring recession, we think it would result more in buying opportunities than a protracted stock market decline.

With 2012 coming to a close, it's our turn to pontificate on what we expect will happen in 2013. Everywhere you turn this time of year, you will find another 2013 forecast, and most seem to be positive this year (which we find a little scary).

There's general agreement that a positive return in the U.S. market will come from multiple expansion, as margins are already high by historical standards. Although we agree that margins seem pretty high already and that the market's valuation is not overly demanding at these levels, we see two alternative outcomes for the market in 2013. First, our research shows the market is close to fairly valued, so we don't expect much multiple expansion. Second, we think there's the potential for positive surprise from revenue growth. There are plenty of signs that things are improving for the U.S. economy, at least marginally, and we expect the economy to continue to strengthen in 2013, which could mean some earnings growth even without further margin improvement.

All that being said, as the market crawls ever closer to fair value, it becomes increasingly difficult to predict its direction. The good news in that assessment, in our opinion, is that stock selection is becoming increasingly important. Over the past five-plus years, there have been never-ending comments about how correlated markets are, and that stock selection no longer mattered--all that mattered was getting the macro calls right and positioning your portfolio accordingly. In 2012 we have seen some signs that stock-picking is starting to have a bigger impact again, and we expect that will be a continuing theme throughout 2013. For example, the S&P 500 is up about 15% this year, a very good year all things considered. However, housing-related names we recommended in 2011 or early 2012, such as Lowe's LOW or First American Financial FAF, are up 40% and 85%, respectively, since the start of 2012.

So where do we see the next pockets of opportunity in the market? Our top picks, as always, come from the ranks of wide- and narrow-moat companies, because we believe these firms will earn excess returns for longer periods of time than their no-moat counterparts. As of mid-December, we have about 30 firms with 5-star ratings among our wide- and narrow-moat coverage list, with a decent population of European firms and energy companies (energy is among our most undervalued sectors at 86% of fair value). However, there are also some large, global companies on the list, such as Apple AAPL and Rio Tinto RIO.

The valuations of European firms under Morningstar coverage are no longer less demanding than we see for our North American companies, on average. Our European coverage is trading at 93% of fair value, while our North American coverage universe is currently priced at 92% of fair value. This could have more to do with our coverage universe in Europe than the overall market condition; the approximately 250 European firms we cover tend to be larger-cap, moaty, higher-quality businesses that the market has sought out over the past year. That being said, these names did rally quite a bit in the past three months, as the market was pricing our European coverage universe at 87% of fair value just a quarter ago.

In addition to energy, we also see the technology sector as particularly undervalued, at 86% of fair value. Several large-cap technology companies have seen their stocks fall materially in recent quarters, from Apple to Hewlett-Packard HPQ. The list of tech stocks down 10% in the past quarter also includes names like Microsoft MSFT, EMC EMC, and Intel INTC. Although some of these stocks have been suffering from a weak global demand picture, others have faced more company-specific woes; in any case, we expect these challenges to clear up in the future and see opportunity in the tech sector. 

Real estate and consumer defensive remain our most overvalued sectors, trading at a 4% and 7% premium, respectively, to our fair value estimates. Investors globally continue to search for yield, and these sectors have benefited. We think this search can be misguided when prices get overly inflated, and investors begin to risk capital in the search for current income. When a wide- or narrow-moat stock trades at a discount to fair value and offers a good yield, you may have something there. But the higher a stock trades above fair value, the more likely it will converge to that fair value and hurt your total return. It is a rare dividend that sufficiently compensates for that risk, so it's critical to look at the whole picture when buying stocks.

Clearly consumer defensive names have also benefited from their relative business stability and high proportion of wide moats. We do generally require a smaller margin of safety around names like this, but we still believe some margin of safety is important. Stocks are all about risk/reward, and the cheaper you buy a great company, the more likely you put the risk/reward equation in your favor.