What's the Market Really Worth?

One way to get a read on the general attractiveness of stocks is to examine the valuations of major market indexes. To do so, we can tap into the work of Morningstar's 100-plus equity analysts.

With more than 2,000 stocks under coverage, our research spans much of the market. We cover all of the stocks included in the Dow Jones Industrial Average, and almost 98% of the assets in the S&P 500 Index. Thus, we can compute meaningful aggregate fair values of those familiar market barometers. Then we can compare the indexes' aggregate fair values with their current market values to gauge whether or not the market, as defined by those benchmarks, is cheap or dear.

The Dow's discount to fair value is about where it was at the close of the second quarter when we last visited this topic. But the S&P 500 looks cheaper than it did three months ago. Still, the market can't be considered dramatically undervalued. Third-quarter volatility did bring a few more bargains to light, but value-priced stocks aren't plentiful across the board.

Market Index Valuations
	Index Value	Fair Value Estimate	% Under- or Overvalued
Dow Jones Ind. Average	14,066.01	14,963.84	-6.4%
S&P 500	1,557.59	1,622.49	-4.2%
Data as of 10-05-07

A look at the most attractive Dow stocks gives some clues as to where the most compelling bargains can be found. Here's a list of the Dow components that have earned 4- and 5-star ratings.

Dow Components with Recent 4- or 5-Star Morningstar Ratings
Company	Fair Value Estimate	Market Price	Moat Rating	Risk Rating	Morningstar Rating
Home Depot  (HD)	$44	$34.22	Wide	Below Average
Alcoa	$52	$38.79	Narrow	Average
Wal-Mart Stores (WMT)	$60	$45.37	Wide	Below Average
J.P. Morgan Chase  (JPM)	$63	$47.58	Wide	Average
Citigroup  (C)	$64	$48.30	Wide	Average
Johnson & Johnson (JNJ)	$80	$66.25	Wide	Below Average
Pfizer  (PFE)	$31	$25.58	Wide	Average
Microsoft (MSFT)	$34	$29.84	Wide	Below Average
Walt Disney Co (DIS)	$40	$35.47	Wide	Below Average
American Express Co (AXP)	$70	$61.10	Wide	Below Average
American Intl Group (AIG)	$80	$69.39	Narrow	Average
Boeing (BA)	$122	$102.25	Narrow	Average
Data as of 10-05-07

Financials
Notice that four financial firms are included on this list:  J.P. Morgan (JPM),  Citigroup (C),  American Express (AXP), and  American International Group (AIG). The subprime mortgage mess that weighed on stocks this summer hit the financials sector particularly hard. But a number of high-quality financial firms were taken down in the sell-off, and many of these companies have only minimal exposure to subprime loans. That offers an opportunity for long-term investors to scoop up some financially sound, competitively well-positioned businesses at bargain prices.

ETFs offer a way to gain diversified exposure to the sector, and several financial ETFs boast compelling valuation characteristics. For example,  iShares Dow Jones US Financial Services (IYG) is trading at roughly a 16% discount to its aggregate fair value and  Financial Select Sector SPDR (XLF) is trading at a 12% discount. For a more targeted play on bank stocks, consider  KBW Bank ETF (KBE), which was featured recently in our "10 Attractive ETFs" article.

Granted, the financials sector still faces some near-term challenges, as evidenced by recent news of charge-offs taken by major banks like Citigroup and  Deutsche Bank (DB). But for patient long-term investors, the valuations among financial stocks are quite intriguing. For more on bargains in the sector, see our recent outlook on the financial-services sector.

Consumer
 Wal-Mart (WMT) and  Home Depot (HD) both have been in 5-star territory for several months, but they got even cheaper during the third quarter, as investors grew concerned that the subprime mess would cast a pall over the broader economy. But the bargains in the sector go well beyond these two Dow components. For example, many other high-quality retail stocks look cheap.  Bed Bath & Beyond  and  Staples  rank among our favorites.

ETFs that focus on the retail sector look cheap. SPDR S&P Retail (XRT) and Retail HOLDRs  boast price/fair value ratios of 0.88 and 0.86, respectively. (PowerShares Dynamic Retail  isn't quite as cheap with a ratio of 0.95.) However, it's important to note that these two ETFs are very different despite their similar names. SPDR S&P Retail provides exposure to midsize retailers like Gamestop Corp. (GME), a video game retailer,  Guitar Center , and casual apparel maker Guess? (GES). However, Retail HOLDRs focuses more on industry leaders like Wal-Mart,  Target (TGT), and  Amazon.com (AMZN).

Several broadly diversified consumer ETFs have price/fair value ratios of 0.90 or below, including  Consumer Staples Select Sector SPDR (XLP), which is dominated by leading consumer firms that are trading at compelling valuations, such as Wal-Mart,  Costco Wholesale (COST), and  Walgreen (WAG).