Our Outlook for the Market

The market continued to weaken along with the economy in the third quarter. It hasn't been a dramatic decline, on average, but the world has changed. We have been through a historic period in financial markets. The short-run fluctuations have been severe, and the economic and political forces shaping corporate performance have been meaningful and exciting--sometimes, a little too exciting. The overall economy has continued to weaken, with implications for current and near-term results at many of the companies we follow. The evolving regulatory environment holds significant implications for investors as well as taxpayers.

We've been thinking hard about the implications of the changes, particularly in our financial services sector coverage. But the basic theme coming out of our fundamental research hasn't changed that much. Taking our individual calls together, the market has looked cheap all year. We think it still looks cheap.

Our fundamental research develops fair value estimates for stocks based on discounted cash-flow analysis. We've been reducing our expectations for earnings and cash flow in 2008 and 2009 for most of the 2,000-plus firms we follow, especially those proving sensitive to the slowing economy. This tends to lower our fair value estimates. But in our discounted cash-flow analysis, the bulk of present value is produced from longer-term expectations. As the stock market has weakened along with greater market concern about near-term economic and financial developments, the prices for the stocks we follow have generally fallen further than our fair value estimates, and the price/fair value ratios in our coverage universe reside at what appear to be attractive levels for long-term investors.

It can be useful to look around for valuable historical analogies at a time like this. It is not a perfect fit, but the 1990-1991 recession may provide some useful historical perspective. At that time, the immolation of much of the U.S. savings and loan industry was associated with weakness in real estate prices and a crisis of confidence in credit markets. During the recession, many stock investors threw in the towel, and the S&P 500 fell nearly 20% in the latter half of 1990. But the market picked up again in early 1991, anticipating the recovery like it usually does. That's why the S&P 500 is in the index of leading economic indicators. It tends to go down before recessions start, and to recover before the overall economy starts growing again. By year-end 1993, the S&P 500 was nearly 50% above its depths in 1990.

It hasn't been easy to stand by our calls during the wild ride in recent months. We weren't always right, to be sure, and we revised our valuations and calls significantly in some spectacular cases. But we are working to learn lessons from these cases, and we believe our framework proves itself successful on balance.

In turn, unless you think our economy rests on a weak, unstable framework from a longer-term perspective, you might share our long-term bullishness on the market at current levels.

Breaking Down the Market
To drill down into specific stocks, our equity research teams have prepared reports outlining current trends and stock values in their coverage areas.

Banks
Investors have begun differentiating banks by quality of assets, funding sources, and leverage employed. But despite the recent rally among high-quality stocks in this sector, we still see some opportunities

Basic Materials
Falling commodity prices and rising costs could crimp margins, but two factors could damp the impact of economic weakness for commodities producers.

Business and Property Services
There are pockets of value and overvaluation among this varied group of stocks, but one theme is worth noting in our valuations.

Consumer
We don't expect a quick end to the roller coaster ride. However, there are a few examples of high-quality firms with strong balance sheets that have dipped into bargain territory.

Energy
The credit crunch and hurricanes have hit the energy sector--and some picks have emerged.

Financial Services
The effects of the credit crisis on the financial services sector vary widely by industry segment, with some segments facing major problems while others coast through with hardly a scratch.

Health Care
With the credit market seizing up, we see the low leverage of health-care companies as a silver lining in a dark cloud hanging over the markets currently.

Industrials
Times are certainly tough, but we think several wide- and narrow-moat industrials firms have positioned themselves to succeed over the long haul.

Media and Telecom
While we think most media and telecom industries are undervalued as whole (with a few notable exceptions), there is considerable dispersion among stocks within some categories.

Tech
We think semiconductor equipment is racing toward the bottom. Time to "be greedy when others are fearful"?

Utilities
Record energy prices and slowing demand have rocked the utility sector. But some areas offer a compelling value for investors.