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Stock Strategist

Measuring the Market's Value

As the third quarter begins, we dig into the fair value of the Dow once again.

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Morningstar has more than 100 equity analysts who estimate fair values for more than 2,000 stocks. Because we have such breadth of coverage, we can assess the valuation of major market indexes by calculating market-cap weighted averages of our fair value estimates for the stocks in the benchmarks. Then we can determine if the indexes are over or undervalued by comparing their aggregate fair values to their current market prices.

Every quarter, we do just that for the three major market indexes--the Dow, the S&P 500, and the Nasdaq 100. As of the end of the second quarter, it appears that the market, as measured by these benchmarks, is still trading right near our estimate of the fair value (see table below), as it was last quarter when we last updated this topic.

Still, there are a few corners of the market where some modest bargains are lurking. For example, cheap stocks have been more prevalent lately among wide-moat industry leaders. In aggregate, all of the wide-moat firms in Morningstar's coverage universe are currently trading at a 5% discount to fair value.

That's why it's not to surprising to see the Dow as the only broad market barometer that's trading below its fair value estimate. It's dominated by big blue-chip stocks, many of which look attractively valued at the moment.

 Market Index Valuations

Index Value

Fair Value Estimate % Under- or Overvalued
Dow Jones Ind. Average 13,408.62 14,204.32 -5.9%
S&P 500 1,503.35 1,501.02 0.2%
Nasdaq 100 1,934.10 1,887.98 2.4%

Data as of 06-29-07

Cheap Dow Components
At the end of the second quarter, 13 Dow components had 4-star or 5-star ratings. (Remember that, generally speaking, stocks trading at large discounts to our analysts' fair value estimates will receive higher, 4-star or 5-star Morningstar Ratings, and stocks trading at large premiums to our fair value estimates will receive lower, 1-star or 2-star ratings.)

  Dow Components with Recent 4- or 5-Star Morningstar Ratings
Company Fair Value
Estimate
Market Price Moat
Rating
Risk
Rating

Morningstar
Rating

3M (MMM) $103 $86.79 Wide Below Average
Johnson & Johnson (JNJ) $80 $61.62 Wide Below Average
Pfizer (PFE) $33 $25.57 Wide Average
Wal-Mart (WMT) $60 $48.11 Wide Below Average
Procter & Gamble (PG) $77 $61.19 Wide Below Average
American Express (AXP) $70 $61.03 Wide Below Average
Coca-Cola (KO) $60 $52.31 Wide Below Average
Home Depot (HD) $44 $39.35 Wide Below Average
Microsoft (MSFT) $34 $29.47 Wide Average
American Int'l Group (AIG) $80 $70.03 Narrow Average
J.P. Morgan Chase (JPM) $63 $48.08 Wide Average
Citigroup (C) $64 $51.29 Wide Average
Walt Disney (DIS) $40 $34.14 Wide Below Average
Data as of June 29, 2007

The table looks largely the same as it did the last time we visited this topic, but there have been a few changes worth noting.

Specifically,  United Technologies (UTX) and  Alcoa (AA) both fell off the list during the second quarter after its Morningstar Rating went from 5 stars to 3 stars. Both stocks rallied strongly during the quarter and moved within range of our fair value estimates for the stocks.

A new face on the list is  Procter & Gamble (PG), which moved from 3 stars to 5 stars over the course of the quarter. The move came about when stock analyst Lauren DeSanto raised her fair value estimate for the firm. DeSanto believes that the risk of P&G's integration of Gillette, which it acquired 18 months ago, is largely in the past. Moreover, she suspects that recent ho-hum quarterly results have caused some investors to lose sight of the firm's long-term strengths--its balanced portfolio of products and proven ability to create blockbuster brands. The stock lost 1.5% during the quarter, and DeSanto thinks that the recent sluggishness has created an opportunity to invest in a firm that has one of the widest moats around at a respectable margin of safety.

ETFs as Windows to Sector Valuations
The change in P&G's star rating had an impact on the fair values of consumer ETFs. Both  Consumer Staples Select Sector SPDR (XLP) and Vanguard Consumer Staples ETF (VDC) are trading at attractive valuations at present. Because these ETFs are market-cap weighted, P&G takes up a lot of room in these ETFs and has a significant impact on their fair values.

Some health-care ETFs also are trading below their aggregate fair values. Consistent with our mega-cap theme, giant pharmaceutical firms represent some of the best values in that sector. As a result, market-cap-weighted health-care ETFs, like  Healthcare Select Sector SPDR (XLV),  iShares S&P Global Healthcare (IXJ), and  Vanguard Healthcare ETF (VHT), look cheap.

Some financial ETFs appear undervalued as well. Again, the biggest names in the sector represent some of the best bargains. Big multinational banks, like  JP Morgan Chase (JPM) and  Bank of America (BAC),are trading well below our analysts' fair value estimates. Going a bit further down the capitalization ladder, super regional banks, such as  BB&T (BBT) and  US Bancorp (USB), also look undervalued. Moreover, some segments of the insurance industry are beginning to take on attractive valuation characteristics. As a result, some financial ETFs, such as  iShares Dow Jones U.S. Financial Services Index (IYG) and PowerShares FTSE Financials (PRFF) look attractive from a valuation perspective.

On the flip side, ETFs that focus on oil and gas service firms, such as iShares Dow Jones US Oil Equipment Index (IEZ) and SPDR S&P Oil & Gas Equipment & Services (XES), are loaded with pricey stocks. Oil stocks have enjoyed a strong rally pretty much across the board, but the oil service sector seems particularly pricey. Big sector leaders like  Schlumberger (SLB),  Halliburton (HAL), and  Transocean (RIG), are trading well above analysts' fair value estimates.

It's a similar story for steel and iron stocks, like  AK Steel (AKS) and  Cleveland Cliffs (CLF), which have also enjoyed a strong rally this year that propelled them into overvalued territory. As a result, it's not surprising that Market Vectors Steel ETF (SLX) looks expensive.

REIT stocks have stumbled recently. In fact,  iShares Cohen & Steels Realty Majors ETF (ICF) lost almost 12% during the second quarter. Nevertheless, REITs ran so strong for so long that they remain squarely in overvalued range, which suggests that there could be more downside to come.

Finally, here's a table of price/fair value ratios for selected 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.

 Price/Fair Value Ratios for Selected ETFs
Price/
Fair Value
KBW Bank ETF (KBE) 0.84
iShares Dow Jones US Financials (IYG) 0.86
Consumer Staples Select Sector SPDR (XLP) 0.89
Financial Select Sector SPDR (XLF) 0.89
PowerShares FTSE RAFI Financials (PRFF) 0.89
Vanguard Consumer Staples ETF (VDC) 0.90
PowerShares FTSE RAFI Consumer Services (PRFS) 0.90
Health Care Select SPDR (XLV) 0.91
iShares Dow Jones US Consumer Services Sector Index (IYC) 0.91
iShares Dow Jones US Financial Sector Index (IYF) 0.91
iShares S&P Global Healthcare (IXJ) 0.91
Vanguard Financials ETF (VFH) 0.91
iShares Dow Jones US Consumer Goods Sector Idx Fund (IYK) 0.92
Vanguard Health Care ETF (VHT) 0.92
iShares Cohen & Steers Realty majors ETF (ICF) 1.17
Market Vectors Steel (SLX) 1.22
SPDR S&P Oil & Gas Equipment & Services (XES) 1.43
iShares Dow Jones US Oil Equipment Index (IEZ) 1.69
Data as of June 29, 2007

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.

Sonya Morris does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.