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Stock Strategist

Our Outlook for the Market

Our sector-by-sector take on the big themes and the best bargains.

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Despite all the hair-pulling of the past few months, the market looks reasonably valued to us. Heading into the fourth quarter of 2007, the median stock in our coverage universe is slightly undervalued based on our estimates of fair value. That's a cheerier picture than three months ago, when strong stock-market gains had pushed most stocks past our fair value estimates.

For most of the past few months, in fact, stocks have appeared cheap to us. The number of stocks rated 5 stars--our highest rating--ballooned to nearly 300 in August. Much of the increase came from financials stocks. Rather than slash our fair value estimates willy-nilly in the wake of the credit mess, our financials team has put in a tremendous amount of work over the past quarter assessing the strength of balance sheets and doing scenario analysis, trying to determine which stocks warrant lower fair values and which do not. In some cases-- Countrywide (CFC) being the best example--we've trimmed our fair value estimate, but continue to believe that at current prices the odds are tilted in investors' favor. Although we're still very much in the midst of the credit-market slowdown, we continue to believe that the stock market has been unfairly punishing many banks and other financials firms.

Since the bottom in August, the number of 5-star stocks has fallen to about 200, or 10% of our coverage list. But even so, that's up from barely 100 heading into the third quarter. As we did then, we still see a disproportionate share of bargains among larger-cap names--stocks including  Microsoft (MSFT),  Citigroup (C), and  Bank of America (BAC). As a result, the market appears cheaper on a market-cap-weighted basis than on an equal-weighted basis. The  SPDRs (SPY) ETF, for example, currently sports a price/fair value of 0.94, which is about 5% cheaper than our average stock. The  Diamonds Trust (DIA) ETF, which tracks the megacaps belonging to the Dow Jones Industrials, stands at 0.93.

Our Outlook by Sector
Every sector looks cheaper to us than it did three months ago, with the biggest changes in valuation coming in energy, industrial materials, media, and telecom. (See table below.) And compared with three months' ago, when only two sectors had median P/FV ratios below 1.0, we now have five sectors that have broken into undervalued territory, albeit not by a lot. We currently see the most attractive median valuations in utilities, consumer goods, and consumer services.

 Sector Valuation Changes

Current Median
Price/Fair-Value

Three Months
Prior
Change
( % )
Business Services 1.00 1.04 -3.9
Consumer Goods 0.97 1.01 -4.3
Consumer Services 0.92 0.98 -5.6
Energy 1.00 1.11 -9.9
Financial Services 0.98 1.03 -4.9
Hardware 1.00 1.05 -4.8
Health Care 1.00 1.05 -4.9
Industrial Materials 1.01 1.08 -6.3
Media 0.98 1.05 -6.5
Software 1.02 1.03 -0.6
Telecommunications 1.05 1.12 -6.2
Utilities 0.96 0.97 -1.2
Data as of 09-19-07.

In the articles below, you'll find detailed summaries of the themes our analysts are watching, as well as which stocks we find most attractive in each sector right now.

Consumer: Undervalued
We think pessimism regarding the consumer has been priced into the market. The most undervalued segments are home supply companies and restaurant firms, in our opinion. We also see a lot of value in clothing, alcoholic drinks, and shoes.

Utilities: Undervalued
No matter which path the economy takes in the near term, we see no other cure for America's aging electrical infrastructure than significant capital investment.

Industrials: Overvalued
The housing slump and credit crisis have punished some of our big-ticket consumer discretionary names.

Software: Overvalued
One of the key trends we're watching: possible drops in IT spending by financial firms hit by the mortgage mess.

Financials: Undervalued
We will have to pay the piper for the happy-go-lucky lending practices of the past few years, and it will be another 18 months at least before we have dealt with all the fallout there. A rate cut may help delay or soften the inevitable, but there are still choppy waters ahead.

Media: Fairly Valued
We recently made further cuts to the fair value estimates for most of the newspaper publishers and a handful of the radio broadcasters that we cover.

Telecom: Overvalued
We have raised our fair value estimate on 34 of 80 telecom firms during the third quarter and only lowered our fair value estimate on one.

Hardware: Fairly Valued
Within the sector, contract manufacturers are undervalued, in our opinion.

Energy: Fairly Valued
The one group within energy that looks undervalued to us: pipelines.

Health Care: Fairly Valued
Medical goods and services, diagnostics, and hospitals have been trading closer to their fair values. However, managed care and assisted living continue to look slightly overvalued.

Haywood Kelly, CFA has a position in the following securities mentioned above: MSFT. Find out about Morningstar’s editorial policies.

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