Our Outlook for the Market

The stock market was looking a little expensive to us a few months ago. But after the downdraft from late April to early June, valuations in general now appear more reasonable. We still think buying opportunities are more likely to be found among wide-moat companies--the subset of firms we cover that we believe hold especially strong competitive advantages.

That's the basic message in our latest quarterly review. Morningstar analysts cover nearly 1,700 companies, and we develop sector and overall market reviews each quarter. At the end of the first quarter of 2010, the median price/fair value ratio for our coverage universe had risen to 1.05, suggesting that our analysts believed the market was at least fairly valued, if not a little expensive.

To put our more recent appraisals into some context, here's a look at our overall market valuation graph over the last five years. In 2006 and 2007, we thought the market was looking fairly valued to overpriced. In turn, things were looking much more attractive in 2008 and into early 2009. Today, that ratio comes in at 0.95.

The market valuation graph allows you to look underneath the overall picture, and to view our appraisals by economic moat rating. The median price/fair value ratio for the  150-plus companies we rate as holding wide economic moats rests at 0.85, significantly below the median ratio for narrow- (0.94) and no-moat (1.00) companies.

Wide-moat firms, which have the strongest competitive advantages, are best insulated from the damaging effects of recessions and inflation. Our wide-moat coverage universe performed relatively well during the 2007 to early 2009 downturn. Since the bottom in the stock market in March 2009, however, stock price gains have been most dramatic among narrow- and no-moat companies. While buying opportunities are still to be found in those categories, we think there is more value to be had in the wide-moat category. In turn, the median price/fair value ratio for our coverage universe is significantly lower on a market-capitalization-weighted basis, suggesting we are seeing more value out there among larger companies.

Morningstar subscribers can use our  Premium Stock Screener to search for companies that we deem the best values, and to do so by our economic moat and uncertainty ratings, as well as by size and industry sector. In turn, here are the results from our latest quarter for the 10 Morningstar sectors, together with qualitative discussions of recent trends and valuation highlights by Morningstar's stock research teams.

Median Price/Fair Value Ratios
Business Services	0.90
Consumer Goods	0.97
Consumer Services	0.97
Energy	0.96
Financial Services	0.93
Hardware	1.07
Health Care	0.89
Industrial Materials	0.93
Media	0.99
Software	1.09
Telecom	0.95
Utilities	0.99
All	0.95
Data as of 06-28-09

Outlook for the Economy

• Investors have itchy trigger fingers.
   
• Higher incomes, low inventories, and an improved manufacturing sector are bullish signs.
   
• Housing and exports will drive the economy longer term.
   
• Government policy is the scariest monster under the bed.

Our Outlook for Bank Stocks

• The sovereign debt crisis in Europe is yet to produce attractive buying opportunities. As the crisis unfolds, we keep our eyes open for potential home runs among European banks.
   
• Despite the crisis in Europe, continuous economic uncertainty, and regulatory reform, the credit and earning trends of most U.S. banks remain positive.
   
• The discussions regarding regulatory action approach the final innings. We believe that the reform would mostly affect large institutions while smaller players would probably get to keep their business models and earnings power generally intact.

Our Outlook for Basic Materials Stocks

• European fiscal tightening casts doubts on the strength of the OECD recovery.
   
• China's efforts to cool its property market could hamstring demand for some industries.
   
• Pending government tax, trade, currency, and regulatory decisions will play a decisive role in picking the winners and losers in this highly uncertain time.

Our Outlook for Consumer Stocks

• Deflationary pressures in consumer packaged goods are abating, but competition is still running high.
• In media, advertising spending continues to improve and, as usual, content is still king in the entertainment world.
• The second half of 2010 in retail will likely be weaker than the first half as difficult comps approach and soft income growth lingers.

Our Outlook for Energy Stocks

• Last quarter, we challenged the deeply entrenched conventional view that oil stocks should be favored at the expense of natural gas stocks. Cracks in this consensus view have formed much quicker than we anticipated.
   
• The incredibly bright future of deep-water drilling constituted the primary subplot of the oil consensus view. In the wake of the oil spill, this subplot met with a sharp twist.
   
• Valuations in the energy sector have become somewhat cheaper in aggregate, though still close to fairly valued as a group. We view XOM, RRC, SE, RIG, and UPL as excellent companies to own over the long term.

Our Outlook for Health-Care Stocks

• The passage of the health-care reform completion didn't result in a sector rally despite its overall benign attributes.
   
• Big Pharma performance was particularly weak in the quarter, primarily as a result of near-term noise. Industrywide trends and fundamentals are attractive, and stocks remain undervalued.
   
• Mergers and acquisitions dominate the industry landscape. More consolidation is expected.

Our Outlook for Industrials Stocks

• Industrial manufacturers are now benefiting from an inventory rebuild cycle, a dynamic we expect to last for a while.
   
• Total inventories likely won't surpass the prior peak for several quarters.
   
• Leading industrial indicators are still very healthy, but signals of an economic slowdown have come from at least one more economically diverse indicator.

Our Outlook for Tech Stocks

• The separation between the winners and losers in the mobile device race continues to widen.
   
• Storage hardware continues to be a hot area in technology.
   
• Increased capital spending by chipmakers will benefit the semiconductor equipment industry.

Our Outlook for Utilities Stocks

• Valuations for power producers still ignore any rebound in power demand beyond 2012.
   
• Big fish likely will continue trolling the mergers and acquisitions market for small fish that need cash or an exit strategy.
   
• First-half demand showed some meager improvements from a dreadful 2009. The third quarter will determine whether demand breaks its two-year slide.