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Our Outlook for the Stock Market

In an overall fairly valued market, it's time to be selective.

Heather Brilliant, CFA, 03/27/2013

--With its recent rally, the stock market is now trading just below fair value, with stocks under Morningstar coverage trading at 97% of fair value, using a market-capitalization-weighted average. This is quite a bit higher than last quarter, when our coverage universe was trading at 92% of fair value.

--We have seen correlations among asset classes start to come down (albeit from very high levels), which bolsters our view stated last quarter, that we think investors focusing on specific stock opportunities should do well given this backdrop.

--Supporting our view that markets will continue to decouple, economic and market performance has meaningfully diverged during the first quarter. The U.S. economy continues to show improvement, while Europe's weakness persists, and uncertainty in Asia has dragged market performance down in that region.

Global equity markets continued their march upward in the first quarter, making undervalued stocks all that much more challenging to find. Our overall coverage universe is trading at 97% of fair value, based on a market-cap-weighted average. Within that, our U.S. coverage is the most expensive, trading at 99% of fair value, followed by Europe at 96% of fair value; Asia is the least expensive at 93% of fair value.

These recent discrepancies in valuation across regions are largely due to stock price changes in the regions as opposed to changes in our underlying valuations. In the first quarter to date, we have seen the S&P 500 rise more than 9%, far outpacing the roughly 3% improvement in Europe or 4% decline in Asia (excluding Japan).

Time to Be Selective
What does this mean for investors? We've gotten a lot of questions lately about the valuation of the overall market--understandably so, given the U.S. market's recent run. A fairly valued market is a challenge from an investing perspective because it doesn't send a clear signal either way. There are a couple of key takeaways for investors, but it boils down to one idea: Be selective with your investment decisions. Just because the overall market is fairly valued doesn't mean that every stock is fairly valued.

First, keep your favorite wide-moat businesses on your watch list, and buy them below fair value. Wide economic moats have the added advantage of compounding returns over time, so generally speaking, we'd rather buy a fairly valued wide-moat firm than a fairly valued business without a moat. Don't forget to be disciplined about your buy decisions, though; a margin of safety still gives you added advantage by further skewing the potential reward in your favor relative to the risk.

Second, focus on individual stocks and themes, rather than investments that expose you to the overall market. Index funds and exchange-traded funds can be great for adding market exposure at lower costs, but if we're right that correlations are declining, we think investors will face better risk/return opportunities buying strong businesses that are undervalued. We also think there are some interesting themes that investors with a long time horizon can take advantage of, such as an improving picture for natural gas in the United States.

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

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