What's the Market Really Worth?

Here at Morningstar, our stock research is guided by the belief that investment success comes from buying shares of businesses when they are trading at discounts to their true values. Consequently, our equity analysts concentrate their efforts on estimating the fair values of the companies that they cover.

But while we focus our attention almost exclusively on bottom-up company analysis, our breadth of coverage (we currently have about 100 analysts covering almost 2,000 stocks), allows us to apply our equity research to the market as a whole. We can compute an aggregate fair value for the market by calculating a market-cap-weighted average of our fair value estimates for the stocks in an index. To determine if the market is over- or undervalued, we then compare the indexes' aggregate fair values to their current market prices.

As we pointed out last month in our quarterly outlook, the market is trading right near its fair value (for a visual representation of our take on the market's worth, check out our market valuation graph). That is confirmed by a look at the major market indexes. None of the major market indexes looks egregiously over- or undervalued, which suggests that investors can expect modest returns from U.S. stocks this year.

Market Index Valuations
Market Index	Index Value	Fair Value Estimate	% Under- or Overvalued
Dow Jones Ind. Average	12,354.35	13,274.59	-6.9%
S&P 500	1,420.86	1,372.25	3.5%
Nasdaq	2,421.64	2,374.42	2.0%
Data as of 03-30-07

Digging into the Dow
As you can see, the Dow is the only major index that's trading below our fair value estimate. In fact, its discount to fair value has deepened as 2007 has progressed. At the end of 2006, when we last visited this topic, the Dow was trading at a 3.6% discount to our fair value estimate. Although our collective fair value estimate for the Dow increased slightly from the end of 2006, the Dow was down fractionally through the end of the first quarter, which helped push its discount to fair value slightly higher.

It's been a mixed year for Dow constituents. Through the end of March, 15 index holdings lost ground, while the remaining 15 increased in value. The results ranged from  Alcoa's  13.5% gain through the end of the third quarter to  Johnson & Johnson's (JNJ) 8.2% slide.

It's not particularly surprising that the Dow is trading at a discount to our aggregate fair value estimate. It's composed entirely of big blue-chip stocks, which have become more attractively valued after trailing small fry for the past several years. In fact, bargains are more prevalent now than they were at the end of last year, when only two Dow constituents warranted 5-star Morningstar Ratings for stocks and just seven earned 4-star ratings.

Here's how the Dow shakes out in terms of the Morningstar Rating for stocks (as a refresher, 5-star stocks are those trading at the largest discounts to our estimates of their fair values, while 1-star stocks are trading at the largest premiums).

5 stars -- 5
4 stars -- 9
3 stars -- 12
2 stars -- 1
1 star -- 2

Alcoa and  Wal-Mart (WMT) were the only 5-star Dow stocks at the end of 2006. Since then, Alcoa has gotten a boost from takeover rumors and has rallied into 4-star territory, but Wal-Mart has continued to trend in 5-star range. Also, two stocks that had 3-star ratings in December--  American International Group (AIG) and  Citigroup (C)--lost a little ground amid the market weakness this year and moved into 4-star territory.

Here are the Dow components that have been awarded 4-star or 5-star ratings by our equity analysts, as of March 30:

Dow Components with Recent 4- or 5-Star Morningstar Ratings
Company	Morningstar   Rating	Fair Value Estimate	Market Price	Moat Rating	Risk Rating
Microsoft (MSFT)		$34	$27.87	Wide	Below Average
Wal-Mart (WMT)		$58	$46.95	Wide	Below Average
American Express (AXP)		$70	$56.40	Wide	Below Average
Johnson & Johnson (JNJ)		$76	$60.26	Wide	Below Average
United Tech. (UTX)		$78	$65	Wide	Below Average
Pfizer (PFE)		$29	$25.26	Wide	Average
Alcoa		$40	$33.90	Narrow	Average
Walt Disney (DIS)		$40	$34.43	Wide	Below Average
Home Depot (HD)		$44	$36.74	Wide	Below Average
Coca-Cola (KO)		$55	$48	Wide	Below Average
J.P. Morgan (JPM)		$63	$48.38	Wide	Average
Citigroup (C)		$60	$51.34	Wide	Average
American Int'l Gp   (AIG)		$80	$67.22	Narrow	Average
3M (MMM)		$89	$76.43	Wide	Below Average
Data as of 03-30-07

ETFs as Market Barometers
Since there are ETFs that track practically every corner of the market, we can also use them to gain insight about the valuation levels of various market segments. For example, ETF valuations tell the same story about mega-cap stocks that we're seeing with the Dow. ETFs that concentrate on the market's biggest names, such as  Diamonds Trust (DIA) (the ETF version of the Dow),  iShares S&P 100 (OEF), and  Rydex Russell Top 50 (XLG) are all trading at discounts to their aggregate fair value estimates.

ETFs can also provide insight into the valuation levels of various sectors. For example, a lot of real estate investment trust ETFs are showing up as extremely overvalued. In fact,  iShares Cohen & Steers Realty Majors (ICF) is trading at a 41% premium to its collective fair value estimate. REITs have enjoyed a strong multiyear rally that has continued to defy expectations, but valuations are reaching nosebleed levels, according to our stock analysts.

On the other side of the coin, homebuilder ETFs are trading at significant discounts to our estimates of their fair values. IShares Dow Jones U.S. Home Construction (ITB), a collection of 22 homebuilding stocks, is trading at approximately a 30% discount to our fair value estimate. Although this sector has recovered somewhat from its mid-2006 lows, it has been barraged by bad news about the U.S. housing market as well as concerns about subprime mortgage loans.

Here's a table of price/fair value ratios of a handful of ETFs. A price/fair value ratio is simply the ETF's price divided by its collective fair value. A price/fair value ratio below 1.0 indicates that the ETF is undervalued, while a price/fair value ratio above 1.0 indicates that the ETF is overpriced.

ETF Price/Fair Value Ratios
ETF	Price/ Fair Value
Energy SPDR (XLE)	1.02
Financial SPDR (XLF)	0.90
iShares C&S Realty (ICF)	1.41
iShares DJ Select Dividend (DVY)	0.97
iShares Dow Jones US Home Construction (ITB)	0.84
iShares S&P 100 (OEF)	0.91
Market Vectors Gold Miners (GDX)	1.14
MidCap SPDRs (MDY)	1.04
PowerShares FTSE RAFI 1000 (PRF)	0.96
Vanguard Telecom Services ETF (VOX)	1.14
Data as of 03-30-07

Morningstar ETFInvestor, our monthly newsletter about the world of ETFs, provides data (including price/fair value ratios) and analysis of ETF fair values in every issue, including the best values of all the ETFs on our coverage list. To check it out, click here. We also delve more deeply into ETF valuations in The Cheap, the Dear, and the Fairly Valued, an article that we write on a quarterly basis.