Our Outlook for the Market

Six months ago, the stock market looked reasonably priced when compared with Morningstar's collective fair value estimates. Since then, the market has been on a tear. Between July 21, when the median fair value of our coverage universe bottomed, and Dec. 31 the Morningstar U.S. Market Index rose 15%. As a result, we're heading into 2007 with a fairly pessimistic view of the stock market.

In fact, the median stock is priced to return single digits over the next three to five years, in our view. As the chart below shows, if you threw a dart at our coverage list, your expected three-year return would be 8.8%, down from 10.5% four months earlier. The median stock in our coverage universe of 1,800 stocks trades at a 12% premium to our estimate of fair value. (To see more on Morningstar's perspective on market valuations, check out our Market Valuation Graph.)

Trends in Valuation
	Average Star Rating	Average Price/Fair Value	Average Expected 3-Year Ret.
08-30-06	2.88	1.07	10.46%
09-30-06	2.84	1.07	10.31%
10-31-06	2.76	1.09	9.67%
11-30-06	2.67	1.12	8.76%
12-31-06	2.66	1.11	8.9%
Equal-weighted averages

The remarkable thing about today's valuations is how little variation we see across sectors. The table below breaks down our coverage universe by Morningstar's 12 economic sectors, and shows equal-weighted averages for star ratings (the higher the better) and price/fair value ratios (the lower the better). The average star ratings cluster between 2.91 for energy and 2.46 for telecommunications. No sector has an average rating above 3.0--meaning the average stock in each sector offers an unattractive return given its risk. (Star ratings are risk-adjusted.)

Valuation Trends by Sector
Sector	Average Star Rating	Median Price/Fair Value	Stocks Covered
Energy	2.91	1.00	151
Consumer Services	2.85	1.00	185
Utilities	2.73	1.02	84
Consumer Goods	2.72	1.03	126
Health Care	2.68	1.03	203
Software	2.66	1.07	65
Hardware	2.63	1.04	167
Business Services	2.62	1.04	193
Media	2.58	1.09	62
Financial Services	2.57	1.05	350
Industrial Materials	2.51	1.06	231
Telecommunications	2.46	1.07	72
Data as of 12-31-06

We've emphasized repeatedly over the past year that quality, blue-chip companies, which tend to be larger, appear relatively cheap. That's still the case. When we look at valuations weighted by market capitalization--which give greater weight to larger companies--the stock market appears more fairly valued. The S&P 500, a cap-weighted index, trades very close to our bottom-up measure of fair value. And as shown in the table below, when we weight by capitalization, three out of our 12 sectors are currently undervalued: software, health care, and consumer services. In practice, this means we expect better returns from the stock market as a whole than from the average stock.  

Valuation Trends by Sector, Market-Cap-Weighted
Sector	Average Star Rating	Average Price/Fair Value	Stocks Covered
Software	3.41	0.96	65
Health Care	3.31	0.97	203
Consumer Services	3.27	0.99	185
Consumer Goods	2.92	1.03	126
Media	2.76	1.10	62
Business Services	2.73	1.11	193
Financial Services	2.72	1.06	350
Hardware	2.70	1.08	167
Industrial Materials	2.67	1.12	231
Telecommunications	2.65	1.06	72
Energy	2.61	1.09	151
Utilities	2.56	1.08	84
Market-cap-weighted averages. Data as of 12-31-06

Major Themes: Sector by Sector
For details on what companies are poised to do well or poorly in 2007 and beyond, we compiled these thoughts from our analyst team.

Information Super Sector: Commentary on the telecommunications, hardware, software, and media sectors.

Services Super Sector: Commentary on the health-care, financial services, consumer services, and business services sectors.

Manufacturing Super Sector: Commentary on the energy, industrial materials, consumer goods, and utilities sectors.