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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.

You may be thinking: That's great, but there are hardly any attractively valued stocks right now. We agree, with only 24 U.S.-listed 5-star stocks as of March 19. However, that has not always been the case. Below is a graph showing the median price/fair value ratio of the stocks under Morningstar coverage. Please note we are using a median here, although we discussed a market-cap-weighted average above, so the price/fair value ratios differ slightly. We have a greater history with the median data (you can view it anytime on Morningstar.com), although we do like the granularity of information we can glean with the market-cap-weighted averages.

It's clear from the chart that we view stocks as slightly overvalued on a median basis at the moment, but you can also see how this has changed over time. Just a year ago, we thought stocks were about 10% undervalued, and at the depths of the financial crisis we had more than 800 5-star-rated stocks. The point is, we think it pays to be patient and wait for a margin of safety when investing in stocks.

On Our Radar
There are several interesting ideas and trends in the sector reports that make up our quarterly outlook. First, the problems in Europe are very far from resolved, but that's pretty much common knowledge at this point (and getting worse with the still-developing events in Cyprus). Our basic materials team adds some insight into this debate as it discusses how weakness in Europe could persist longer than the market expects, when it comes to materials or industrials firms that produce in Europe for the local market. That's because long-standing market rigidity, particularly labor market concerns, is preventing companies from shuttering factories or plants in Europe. For those investors interested in benefiting as Europe recovers, we'd recommend particular caution for basic materials and industrials names because of this concern. Some of this is priced in, as basic materials remains our least expensive sector at 86% of fair value, but it could be a long wait for recovery in Europe in this sector. We point investors toward names with less European manufacturing exposure, such as Compass Minerals CMP or Steel Dynamics STLD.

Energy is the other sector that remains materially undervalued, and we find a particularly compelling theme in U.S. natural gas. After years of depressed natural gas prices, we believe the landscape for U.S. natural gas fundamentals is finally improving. For the skeptics, consider these data points: Production growth has begun to flatten, the dry gas rig count is extremely low, and natural gas storage levels have fallen 15% in the past year (although they remain 15% or so above the five-year average). Our energy team shares the full picture in the energy quarterly outlook, and we think there's a very compelling opportunity here. We point to Ultra Petroleum UPL as a good way to participate in this improvement. We also think there's the potential for meaningful upside in Apache APA and National Oilwell Varco NOV in this sector.

Third, the U.S. economy continues to show signs of improvement. From construction to agriculture to industrial production, we continue to believe the U.S. economy has enough going for it to result in reasonable GDP growth without meaningful inflation. In our industrials sector outlook, we look at diversified industrials for insight into the overall economy and find expectations among 19 diversified industrials of 2.5% revenue growth and more than 11% earnings per share growth. Although we expect that EPS growth rate will be driven at least in part by nonfundamental factors (such as share buybacks and merger and acquisition activity), the revenue growth number is in line with our economic expectations. Please see our economic outlook for more details.

On the overvalued side we still have consumer defensive and real estate, trading at 8% and 7% premiums, respectively, to our fair value estimates. With bond valuations stretched, investors continue to search for yield, and as we have discussed here in the past, these sectors are filled with stocks with better-than-average dividend yields. The market has clearly recognized that, however, and the consumer defensive sector is just about as expensive as we have seen it in the past 10 years. We think Molson Coors TAP and Sysco SYY look somewhat attractive, although neither is quite cheap enough to reach 5-star territory.

Stocks vs. Bonds
Investors face a difficult dilemma at the moment, given the choices of stocks and bonds. As Dave Sekera notes in our quarterly outlook for bonds, we view U.S. corporate bonds as fully valued at current spreads. With stocks and bonds fully valued, the decision of where to put one's money is not an easy one from a top-down perspective.

Although neither asset class looks particularly attractive based on valuations, we'd rather own stocks than bonds in this environment. The U.S. economy is improving, and expectations for the depth of improvement remain relatively muted, giving the stock market a chance to surprise on the upside. However, any acceleration in economic growth could come with inflation, which tips us even further in the direction of favoring stocks. Combine that with the lower correlations we have seen year to date among markets around the world, and we think investors will be better served in 2013 to stick to specific stock ideas and themes.

Please see our detailed take on each sector in the reports that follow.

More Quarter-End Outlook Articles

Economy

Credit Market

Credit Sector Updates and Top Bond Picks

Basic Materials

Consumer Cyclical

Consumer Defensive

Energy

Financial Services

Health Care

Industrials

Tech & Communication Services

Utilities

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

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