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Our Outlook for the Stock Market

The market is still reasonably close to fair value, but we see some potentially deep shifts under the surface.

Heather Brilliant, CFA, 06/26/2013

--Although the market continued to rise in the second quarter, stocks are now trading at 94% of fair value, a small improvement from the 97% we saw last quarter, based on stocks under Morningstar coverage using a market-capitalization-weighted average.

--The risk/reward ratio does not favor bond investors, with credit spreads tight and the potential for higher rates looming.

--We think the outlook for equity markets is reasonably good over a longer time horizon, given pockets of undervaluation, an overall market valuation that is not too demanding, and our expectation that the bond market will correct, sending more assets toward equities. We expect higher volatility in the short term, however.

When we look at our valuation data on stocks, which is based entirely on our bottom-up views of each company we cover, not much has changed: The market is still reasonably close to fair value, the United States is still the most overvalued market, and we still see the cheapest valuations in the energy and basic materials sectors.

However, a look at the global macroeconomic picture and the bond market reveals some potentially deep shifts under the surface. Japan, a market darling just a quarter ago, has plummeted. Treasury volatility has spiked, and Treasuries themselves have seen a meaningful increase in yield (albeit off a very low base). And the economic picture seems to be worsening on the margin, with purchasing manager surveys declining to below 50 in markets across the world.

In my opinion, there are a couple of key insights that can be gleaned from this collection of data points. First, it has become increasingly clear that the bond market is laden with downside, and we see very little upside potential to offset that risk. We have been commenting on the uneven risk/reward in bonds for several quarters, but fortunately for bond investors, rates remained very low and credit spreads continued to tighten. We think the picture is changing. As my colleague Dave Sekera says in his credit outlook, "We think the preponderance of credit spread tightening is likely to have run its course." Add to that Dave's analysis that Treasuries generally trade about 245 basis points above inflation (which at today's inflation levels would mean Treasuries at 3.25%-3.5%), and we could easily see the bond market hit by flat or widening spreads and another 100-basis-point increase in Treasuries--not a pretty picture. Will this happen in the next quarter? No one knows. But I believe the risk/reward equation is not in your favor in the bond market today.

Second, equity valuations are not as stretched as it may appear at first glance. Although many market participants rely on the Shiller price/earnings ratio to argue the markets are materially overvalued, that measure averages earnings over the past decade and therefore includes a period of very low earnings during the financial crisis. This doesn't make it wrong; it is exactly what it claims to be: a rolling 10-year historical average. I'm not claiming that the market is cheap; according to our bottom-up analysis using forecast earnings, it's somewhere between 6% undervalued (using a market-cap-weighted average price/fair value ratio) and 1% overvalued (using the median price/fair value ratio of our coverage universe). But we don't see the market as materially overvalued at these levels, either.

In a market trading at close to fair value, it's important to pick your opportunities wisely. We still see basic materials and energy as the most undervalued sectors, trading at 82% and 86% of fair value, respectively (again using the market-cap-weighted average). These are both clearly very economically sensitive sectors, and given that we're more optimistic on the outlook for the U.S. economy than for Europe--albeit a little less optimistic than we were last quarter--our best ideas in these sectors focus on opportunities that are relatively more exposed to the U.S. or leverage a company-specific story. Devon Energy DVN is an example of this, as our estimates of the company's future cash flows show the stock trading at a 45% discount to our fair value estimate. You can read the details of the story in our Analyst Report on the stock, but in a nutshell, we think the company will navigate a transition to more oil-heavy assets better than the market is currently expecting. We expect it will do well even with tepid U.S. economic growth, based on its own internal strategic decisions in future quarters to refocus its business where it can extract the most value.

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

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