Our Outlook for the Stock Market

We thought the market looked pretty cheap back in March, but stocks have appreciated toward--and in many cases past--our fair value estimates in recent quarters. While we still see opportunity within a variety of sectors, it's primarily among firms with wide economic moats.

That's the bottom line from our big-picture review. Morningstar equity analysts cover about 1,700 companies and develop sector and overall market outlooks on a quarterly basis.

One way to read our collective take is with Morningstar.com's market fair value graph. This tool tracks the median price/fair value ratio of our coverage universe over time.

We've recently upgraded this tool, allowing you to drill down to see our assessments across moat, uncertainty, sector, and industry categories. You can couple that with our in-depth sector discussions below, which include a review of the individual stocks our equity research teams have identified as some of the best values in the market right now.

Back in 2005-2007, our median price/fair value metric suggested the market was no bargain. Market prices in general were aligned with or somewhat above our fair value estimates, let alone offering a margin of safety. As the financial crisis and collapse in market confidence gathered steam in 2008 and early 2009, we grew pretty bullish, collectively, and our median price/fair value ratio fell sharply. At the market low in March 2009, we had more than 500 5-star stocks.

With the 60% runup in the S&P 500 since then, market prices much more closely approximate their fair values today, at least in the aggregate. In fact, as of Dec. 22, the median price/fair value ratio for our overall coverage universe was 1.02.

So what's next for the market? Our director of equity research, Pat Dorsey, takes a broad look in his accompanying analysis. His conclusion: It's possible the market has upside from here, but we'd either need a heroic rebound in earnings or some significant multiple expansion, neither of which is a fat pitch. Meanwhile, Robert Johnson, our economic expert, argues in his accompanying commentary that there is indeed reason for optimism on the economy. He sees good growth for the next few quarters and believes the rebound could be faster and stronger than many expect.

Surveying the Sectors
Though the market as a whole may be fairly valued, we also view the stock market as a market of stocks, and we do see pockets of opportunities among individual sectors and firms. Looking under the hood of the median overall price/fair value ratio, our appraisals differ significantly across our moat ratings, for example. The rally since March 2009 has been relatively concentrated among the firms hardest hit by the financial and economic crisis, and the median price/fair value ratio for the firms that receive our "no moat" rating (firms with relatively weak competitive positions) has risen to 1.08. We see the most significant values in the smaller class of "wide" economic moat firms. We have assigned wide moat ratings to only 160 companies among the 1,700 firms we follow.

Median Price/Fair Value Ratios
No Moat	1.08
Narrow Moat	0.99
Wide Moat	0.92
All Stocks Under Coverage	1.02
Data as of 12-22-09

We don't have many significant sector-wide calls. Our health-care team still brings some of the most bullish cases to the table, as they did in the third quarter. Within the health-care sector, the median price/fair value ratio for the 35 biotechnology firms we follow comes in at 0.88, for example. On the flip side, our information-technology analysts (reflected in the hardware and software sectors in the table below) are seeing a few red flags out there.

Our fair value estimates in the other six main sectors are more closely in line with market prices, but again, there is a significant amount of variation at the individual stock level. We tend to see better opportunities among companies with the largest market capitalizations, for example. But as a general rule, wide moat firms can be found in all of our sectors, and wide-moat companies are where we see most of the value out there these days.

Median Price/Fair Value Ratios
Business Services	1.01
Consumer Goods	1.04
Consumer Services	1.03
Energy	1.00
Financial Services	0.95
Hardware	1.17
Health Care	0.91
Media	1.08
Software	1.14
Data as of 12-22-09

You can learn more about the opportunities, trends, risks, and performance drivers identified by our analyst research groups in the articles listed below:

Banks
The pressure to repay TARP is moving down to regional banks, but with commercial loans still deteriorating and consumer loan losses continuing to climb, some banks will think twice before looking to return TARP capital.

Basic Materials
Many factors are pointing in the right direction for basic materials companies in 2010, but capacity expansions (and possible oversupply) and demand shifts due to environmental concerns are longer-term headwinds. And then there's China.

Business & Financial Services
While we don't view stocks in these sectors as across-the-board cheap, we think the market rally has left behind some pockets of opportunity, including for-profit education and insurance brokers.

Consumer
The recent rally in the stock market has caused several of our favorite household & personal products and media companies to trade closer to our fair value estimates, but some are still worth keeping on your radar, and a few retail names remain out of favor with investors.

Energy
Higher oil prices, improving sentiment about the future of gas prices, and healthier credit markets combined to drive a rally in the middle of 2009, with energy stocks now looking fairly valued as a group.

Health Care
As reform starts to materialize, the veil covering health-care stocks is lifting, and investors' sentiment is starting to improve. 

Industrials
Several metrics within the industrial space suggest activity that bottomed in early summer is on the upswing. We look for further recovery next year; however, only a few names still look attractively priced.

Tech & Telecom
The massive runup since March has moderated slightly, but without a material pullback, most of the technology and telecom sector remains fairly valued. And if the substantial and lasting economic rebound that appears to have been priced in fails to materialize, the recent rally could easily reverse.

Utilities
Going into the fourth quarter, utilities were the forgotten sector of 2009, but the market did not overlook this anomaly for long. However, we think the market is missing the growth potential in some diversified utilities.