Our Outlook for the Market

The market looks increasingly dear to us today, after rising roughly 5% since our last quarterly review. That increase has run a little ahead of the mixed, but generally upward revisions to our earnings projections and fair value estimates. However, we still see attractive values in individual industries and firms and, in particular, among  wide-moat companies. That's the basic message in our latest quarterly review.

Morningstar equity analysts cover about 1,700 companies, and we develop sector and overall market outlooks on a quarterly basis. One way to get a read on 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 and allows 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.

At the date of our last quarterly review, in December 2009, the median price/fair value ratio for our overall coverage universe was 1.02. Today, that ratio is up to 1.05. It has basically been fluctuating around 1.0 since late 2009, after the significant market rally that began about a year ago.

The median price/fair value estimate ratio increased in the last quarter in all three of our economic moat rating categories, but we still see greater opportunity in the smaller, wide-moat category. This category includes those firms we deem as possessing significant competitive advantages and the potential for superior returns on capital. The median price-fair value ratio for these 160 companies is at 0.96, below the median ratios for the narrow (1.01) as well as no-moat (1.14) buckets.

We still don't have much in the way of sector-wide calls right now, at least at the higher levels of aggregation. Our health-care team was relatively bullish last quarter, but even there, we are seeing fewer attractive values these days.

Median Price/Fair Value Ratios
Business Services	1.00
Consumer Goods	1.07
Consumer Services	1.11
Energy	1.02
Financial Services	1.03
Hardware	1.17
Health Care	0.98
Industrial Materials	1.08
Media	1.08
Software	1.17
Telecom	0.99
Utilities	1.04
All	1.05
Data as of 03-25-09

Our market valuation graph allows you to poke around in all the industry groups underlying these sectors, supplementing our sector discussions (including our best individual stock ideas) below.

For example, our "industrials" category includes firms we identify in the "general building materials" and "residential construction" categories. Hammered in the recession, stocks in these groups have been relatively dormant amid a developing economic recovery. We have yet to see a significant housing recovery, to be sure, but the price/fair value ratios in those industry groups are among the lowest in our coverage universe right now.

A notable industry at the pricey end of the scale is staffing and outsourcing services, where stock prices have had a significant run in recent months. If that market reaction augurs well for stronger labor markets, a better housing recovery could be on the cusp as well, supporting our take on housing-related stocks.

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

Our Outlook for Bank Stocks

• With mortgage and consumer loan defaults appearing to bottom, commercial real estate and construction loans remain the Achilles' heel of many banks
• Weak demand for loans will impede organic growth opportunities, likely turning management teams' eyes toward the M&A market even before regulators finish purging the system of troubled banks
• After passing the health-care bill, legislators are finally putting banking industry reform on the front burner.

Our Outlook for Basic Materials Stocks

• Performance in the basic materials sector will be driven by emerging-markets demand, government regulation, and government spending. These look to be tailwinds through 2010.
• While application rates for fertilizer have shown a promising trend recently, continued concerns about oversupply may damp long-term profitability.
• Steel production in China and India continues to be the key driver for coal and iron ore pricing. Robust demand through 2010 will be a powerful potential catalyst for pricing.

Our Outlook for Business & Financial Services Stocks

• Asset managers are likely to see a more tangible impact this year from the consolidation that has taken place in the broker-dealer channel.
• Based on relative intermediate fund performance coming into 2010, we believe BlackRock, T. Rowe Price, Waddell & Reed, and Janus are best positioned to drive equity inflows in the near term, but expect the payback from Janus' stronger fund performance to be weaker given the limited reach of its distribution network.
• Most of the sectors in our coverage are trading close to fair value, but education and insurance brokers look fairly cheap.

Our Outlook for Consumer Stocks

• Retailers square-off against consumer packaged-goods firms.
• Buyouts (rumored and actual) gain momentum as credit markets loosen.
• Cyclical laggards--restaurants and grocers--begin to stabilize.

Our Outlook for Energy Stocks

• While the current outlook for supply/demand fundamentals favors oil, we believe that higher full-cycle shale gas extraction costs and potential fuel price arbitrage will better balance the scales with gas in the longer term.
• However, in the near term, we are cautious on smaller E&P firms with high operating/financial leverage as they may struggle to weather temporarily depressed gas prices and/or potentially higher interest rates during the next 12-24 months.
• While valuations in the Energy Sector appear fair, presenting few attractive near-term investment opportunities, we view XOM, RRC, SE, DVN, and BRGYY as excellent companies to own over the long term.

Our Outlook for Health-Care Stocks

• With health-care reform nearing completion, regulatory uncertainty surrounding health-care stocks should largely dissipate.
• Reform implications vary by sector, but the overall impact is largely neutral.
• Investors' focus should shift to industry fundamentals which appear attractive. Health-care stocks remain undervalued.

Our Outlook for Industrials Stocks

• Activity in auto production is picking up in March, but housing and truck production are still a bit slow.
• The Institute for Supply Management's PMI survey points to continued strength in manufacturing.
• Industrial data points to growth in overall employment coming soon.

Our Outlook for Tech & Telecom Stocks

• The rapid growth of the smartphone market continues to be a defining trend in the technology industry. Microsoft plots a mobile comeback with Windows Phone 7.
• The growth of smartphones, along with increased solid-state drive adoption, will likely strain available flash memory production capacity.
• Tight flash capacity may catalyze a semiconductor equipment investment cycle, which would benefit KLA-Tencor and Applied Materials.

Our Outlook for Utilities Stocks

• Independent power producers have significant leverage to an improving economy.
• Attractive combinations of earnings growth and dividend yield still exist in the sector.
• Rising bond yields and inflation present longer-term threats to regulated utility returns.

Outlook for the Economy

• Consumers start the ball rolling.
• Production and manufacturing show signs of life.
• Business investment just beginning to make its move.
• Productivity growth should drive exports.
• Wage growth and inflation continue to do battle.