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By Timothy Strauts | 07-22-2014 01:00 PM

What Opportunities Are There in an Overvalued Market?

Valuations are high, but Morningstar's quantitative equity ratings uncover two key areas to consider.

Tim Strauts: Today, we're going to look at equity market valuations through the lens of Morningstar's quantitative equity ratings. You may be asking, "What are the quantitative equity ratings?" The quantitative equity ratings were created to expand upon and complement Morningstar's Analyst Ratings by replicating their fair value outputs using a machine-learning algorithm known as a random forest. The algorithm only requires 12 easily attainable inputs per company, allowing the model to estimate the price/fair value for a large number of stocks.

Since Morningstar began capturing quantitative equity ratings in June 2012, the quantitative model has created fair value estimates for 45,000 companies worldwide. Given the breadth of coverage, individual quantitative equity valuations and moat ratings can now be aggregated up to the fund level, sector level, country level, or any level in between to provide macro insights.

When we look at the U.S. market, what we see here is the typical Morningstar Style Box with size of company on the vertical access and style on the horizontal. When we look at the total market, the U.S. market currently--based on the quantitative equity rating--is 5% overvalued. And actually, when we look at the individual style boxes, the areas of the market that are most overvalued are the growth side of the style box and the small-cap side. So, actually, the only area of the market that is slightly undervalued is large-cap value right now.

In this next style box, we've put the moat rating on the vertical access and the uncertainty rating on the horizontal. Here, you can see that the most overvalued area of the market is high-uncertainty stocks, and the one area that offers the best value is wide-moat companies with low uncertainty. From looking at the two style boxes, you can see that the U.S. market is generally overvalued. But if you are looking for some opportunities, large-cap value and wide-moat companies with low uncertainty are the places to look.

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