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Quarter-End Insights

Our Outlook for the Market

Which sectors have the most room to run?

The market looked cheap to us last quarter, and it still looks cheap.

In recent months, our analysts have tempered their near-term assumptions for revenue and profitability amid the persistent, sharp economic recession. As a result, we've been reducing more of our fair value estimates. However, stock prices fell a bit further, leading to more attractive valuations.

In our coverage universe of more than 2,000 stocks, the average star rating rose slightly from 3.7 in December 2008 to 3.8 in March 2009, while the median price to fair value ratio declined from 0.69 to 0.65.

The large difference between existing prices and our higher fair value estimates suggest we expect a significantly positive market return over the next few years. With an average uncertainty rating of "medium," the market as a whole is trading at a discount sufficient enough to suggest a 5-star (consider buy) rating.

  Dec 08 Mar 09
Average star rating 3.7 3.8
Market-cap-weighted star rating 4.1 4.2
Median P/FV 0.69 0.65
Arithmetic average P/FV 0.71 0.67

Breaking Down the Valuations
Some of the best values appear to be in sectors hardest-hit by the economic environment. Among the 41 industry groups covered by our 100 analysts, the price/fair value ratios for homebuilders, home improvement retailers, automakers, industrial machinery manufacturers, packaging companies, and transportation services firms are among the lowest in our coverage universe. We don't necessarily have higher uncertainty ratings in sectors with the cheapest valuations, however. For example, we see opportunity in many health-care services and medical equipment companies, too.

We see relatively less favorable valuations for companies in the precious metals, energy, utilities, and media sectors. But we think valuations for individual firms, not sector generalizations, matter most. There are values to be found within the more expensive sectors as well.

Earnings Expectations
We don't have very rosy expectations for 2009 underneath our fair value estimates. We expect only about one-fourth of the 2,000-plus firms in our coverage universe to report higher revenue growth in 2009 versus 2008, down even further from the one-third of firms that achieved higher revenue growth in 2008 versus 2007. In turn, our projections imply a further decline in the median operating profit margin in 2009. Further down the road, we're expecting three-fourths of the companies to have higher revenue growth in 2010 than in 2009, and we project about 80% of companies to report higher operating income in 2010 than they did in 2009.

Looking at individual industries, our earnings expectations for 2009 are quite mixed. But a coherent story emerges from the bottom-up approach of our 100 analysts. We're looking for a further decline in operating income in a majority of the 28 industry sectors that are especially sensitive to overall economic conditions. But we expect a recovery in earnings in a variety of industries linked to consumer discretionary spending, including manufacturers, retailers, and service providers. We're still monitoring current conditions closely, but it looks like consumers may lead the way out. These are near-term earnings expectations, not stock valuations, and we repeat that we see some of the most attractive valuations in sectors that were hardest hit by the recession--even in sectors where we aren't expecting a rebound in earnings this year.

For more in-depth sector and industry analysis, including our current top picks in each group, please see the reports below--and happy hunting!

Given the extremely challenging and uncertain macro outlook, we think investors should stick to the high ground in this space.

Basic Materials
Weak demand abounds, with some pockets of strength and a few surprising outcomes.

Business & Financial Services
Our near-term outlook for the business and financial services industries we cover is negative in any kind of absolute sense, but we think this kind of environment demonstrates the power of economic moats.

The best investments in the consumer goods and services sector are concentrated among companies that sell necessities--i.e., traditional supermarkets and consumer packaged goods firms.

You'd think the energy industry might be numb to bad news by now, but unfortunately the bad news kept coming in the first quarter.

Health Care
Health-care reform proposals and the 2010 budget wreaked havoc across the health-care sector, while a second news wave brought word of mega-mergers. Get our take on the regulation worries and what other deals could be next.

The near-term may be dim, but as demand eventually picks back up, we think the machinery, transportation, and materials necessary to support infrastructure projects will strongly benefit.

Media & Telecom
Last quarter we highlighted the extreme divergence between the good and the bad within the media and telecom sector, and things have only gotten worse for weaker firms over the past three months.

The technology supply chain, from chips to hard drives, has done an admirable job of taking out production capacity in the last few months. As a result, inventory destocking has run its course for now.

Financing, demand, and fuel price concerns have besieged the utilities sector. But as credit markets stabilize and the economy recovers, we could see more-attractive opportunities emerge among some of our top merchant and regulated utilities.

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