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By Paul Justice, CFA and Michael Rawson, CFA | 05-16-2012 01:00 PM

Stock ETFs Worth Sticking Around For

Although the stock market isn't a screaming buy today, investors shouldn't completely abandon equities for bonds. Here are some stock ETFs that are worth a closer look.

Paul Justice: How much yield do you really need?

Hi, there. I'm Paul Justice, director of ETF Research at Morningstar.

Investors over the last year have really been fleeing out of equity markets and putting more funds into bond funds at a time when interest rates are really near historic lows.

In the ETF space, we saw over $120 billion come into ETFs, but $53 billion of that went into fixed-income products. In the mutual fund landscape, the story is even more stark. What we saw is over a $100 billion withdrawal from equity funds, and $170 billion went into mutual funds in the fixed-income space.

To me this may be a disturbing trend. While we're proponents of getting your asset allocation right, your stock/bond mix correct, we think that people are afraid of equity markets at this point in time--a fear that may not be justified to this extent.

To talk a little bit about equity valuation as we see it in the broader market space, I have Mike Rawson joining me, one of our ETF analysts who covers our broader index funds.

Thanks for joining me, Mike.

Mike Rawson: Thanks for having me, Paul.

Justice: So, with investors fleeing over to bonds from stocks, and potentially in a fear-driven state, do you think that this is a rational move at this point in time? What do you think the S&P 500 holds for people today?

Rawson: Well, we think the S&P 500 is fairly attractive on a number of valuation metrics. First of all, the valuation metrics we value most highly here at Morningstar is our Morningstar fair value estimate, which is driven by the equity analysts who cover 465 out of the 500 stocks in the S&P 500.

Justice: So, we've got it covered?

Rawson: Yes. Each of these analysts build discounted cash flow models on the stocks that they cover, and what we can do, then, is we can aggregate those fair value estimates on the individual stocks up to the index level and get a valuation for the index.

So, for the S&P 500 right now, they see the S&P 500 trading at a fair value of around 1,500. The current price is about 1,350, so that leads to a price-to-fair of about 90%, which is somewhat attractive.

Justice: So, roughly fairly valued, if we take it within a standard deviation of what people would say. Maybe slightly attractive.

Rawson: Sure.

Justice: So, that's one way to go about it. It's been a very effective way to go about it, too, over the last seven years.

What other metrics are you looking at on the S&P 500--perhaps from a top-down view or more of a fundamental basis?

Rawson: Well, there are a couple of other commonly used metrics, such as price-to-forward-earnings. So, if you look at Wall Street consensus earnings estimates for 2012, we're looking at about $105 per share on the S&P 500. That puts the price-to-forward-earnings ratio on the S&P 500 at about 13 times, which again is moderately attractive--maybe not a screaming buy, but still not overvalued by any means.

Justice: Now, if we smooth it out a little bit, there is a common way, the Shiller P/E ratio, which kind of smoothes the earnings over time. Can you talk a little bit about that?

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