Our Outlook for the Market
Broken record, or a consistent message? The market still looks cheap to us.
Economic weakness intensified in recent months, and the downturn in stock prices gathered greater steam--at least until recent weeks. After a brutal September, October, and November, the S&P 500 hit its low for 2008 during the day on Nov. 21. At 741.02, the S&P had been cut in half from year-end 2007.
Aggregating our bottom-up research on individual companies and adding those takes together, our bottom line has been pretty consistent all year--the market has been and still looks cheap.
Morningstar.com's Market Valuation Graph (see snapshot below) computes the median ratio of stock price to fair value across our coverage universe. As the economic downturn intensified during 2008, we've been reducing our revenue and cash flow expectations for many of the 2,000-plus companies we follow, leading to lower fair value estimates. But stock prices raced downward even faster, leading to lower price/fair value ratios. Our discounted cash flow models are more sensitive to changes in longer-term expectations than in near-term expected corporate performance--one reason our fair value estimates have held up relative to the market.
A Bottom-Up Perspective
For related reasons, recessions can provide some of the best opportunities for patient, long-term investors to buy into moaty companies, and even to buy into the market generally. Since World War II, investing in the S&P 500 only during recessions, even only at the beginning of recessions, has beaten putting money into the market continuously.
However, the current recession and associated stock market activity have underscored the mantra that "past performance does not guarantee future success," at least so far. Even if you had waited until June, six months after the recession started (and after a 12% decline in the S&P 500), a fresh investment in the market would have shriveled 40% by Nov. 21.
At Morningstar, we emphasize bottom-up, fundamental research on individual firms, not market calls. In turn, we recommend stocks only after their price falls below a "margin of safety"-- namely, a discount to our estimate of their fair value that is commensurate with our estimate of their fair value uncertainty. We've put more firms in higher uncertainty categories this year, especially in the financial-services area. And we've widened the margins of safety to boot. But the generalized hailstorm has left a lot of firms looking individually cheap, if not on fire sale, these days. For example, we've assigned our highest 5-star (consider buy) ratings to over half of the Dow 30 industrial stocks, with only one firm rated below the neutral 3-star rating.
The Market vs. the Economy
What will it take to get stock prices and our fair value estimates more in line with one another? The depressed economy and financial markets have been walking down the aisle together, at least until recent weeks. If generalized economic improvement is needed to spark more cash flow into the stock market, it may not make sense to wait for the economic data to improve before investing money in the market. The market will likely improve well before evidence arrives that the economy has. In fact, if you are looking for evidence of an upturn in the economy, one good place to look is in the stock market.
Even when economic data are published regularly, they cover time periods a month or two in the past. On the other hand, stock prices are timely reads, available almost continuously. Economic data can be materially revised, especially around turning points, but stock prices are unrevised. Stocks can be subject volatile day-to-day mood swings, to be sure, but in reflecting investor and business confidence, they also provide a read on expectations in a timely manner.
Since that Nov. 21 low point, the market has been behaving better, and there may be more than meets the eye on that score. The stock market is included in the index of leading economic indicators, and its improved performance before the end of past recessions has been very consistent (see image below). In turn, within overall market indexes, insights can be gleaned from firms and industries that are especially sensitive to the economy, such as staffing services firms, homebuilders, and heavy machinery manufacturers.
We don't focus on stock prices too closely at Morningstar. We focus on fundamentals in individual companies and our assessments of their competitive advantages. But expectations of generalized conditions and business confidence are fundamentals worth respecting, especially in the financial-services sector, and the stock market provides good input on that score.
We have not yet seen a declared end to our current recession, which the NBER Business Cycle Dating Committee recently determined we entered in December 2007. In turn, we haven't had much yet in the way of several months of improving stock performance, like we had before the end of previous recessions. The S&P has risen about 15% since Nov. 21, however. Time will tell if we are getting into the early stages of an "end-of-recession" bull market.
Sector and Industry Insights
In a poll we recently conducted, most Morningstar stock analysts expected significant further economic deterioration. But our discounted cash-flow models include projections for stronger revenue gains and positive earnings growth for many industries in the 2010-12 time frame, and those expectations look very reasonable, if not conservative.
We see little reason for cheer in the new year, as we expect loan losses to rise further and bank earnings to remain significantly depressed. At the same time, we see the downturn as an opportunity to purchase shares of some high-quality, lower-risk banks.
Weak demand, falling prices, and production curtailments were the norm for basic materials companies in the latter part of 2008. Dynamics in the copper, chemicals, and fertilizer markets provide salient examples of the trends affecting basic materials companies.
Business and Property Services
On aggregate, all of the segments within the business and property services sector are trading below their fair value. That doesn't mean that every stock is cheap, but it does mean that as a whole we think the sector is on sale.
Given that the U.S. could be headed toward an extended economic downturn, we are focusing on a combination of lower-risk firms that lean more toward consumer staples and that have dominant brands, and slightly higher-risk firms with better long-term growth opportunities.
The credit crisis and a lower commodity price environment continued to rip through the energy industry in the fourth quarter--and oil & gas producers are scaling back.
We outline the good (data processing), the bad (insurance), and the ugly (money management) based on opportunity and performance, and offer some stocks that deserve consideration.
The market has challenged the defensive nature of health care, and we believe the punishment of these sectors in response to near-term weakness in demand has been too severe.
Slowing demand and dollar strength will hurt in 2009, but values remain, and we're actually quite bullish on the share prices for many of our names.
Media and Telecom
This sector is a tale of two extremes. Telecom offers relative stability, but old media is in big trouble.
Unless and until the credit markets thaw, we do not expect technology spending to rebound in a material way. Get our take on the developments in the major tech sectors.
Financing, demand, and fuel price concerns have besieged the utilities sector. But despite these challenges, we see long-term value.