Market Still at Fair Value

Investors in 2010 weren't treated to the rollercoaster volatility that the markets experienced in 2008 and 2009. It was hardly a sedate year to be sure, with some bumps along the way, but one thing remains the same now as it did 12 months ago: Stocks on the whole remain fully valued.

Although the recovery has been halting at times, it appears to be firmly in place. The Morningstar U.S. Market Index is up 14% over the last 12 months as mostly positive economic data and corporate earnings continued to roll in. At the same time, our team of equity analysts has raised their fair value estimates as the prospects for the firms they cover brightened. The rally has been justified by improving fundamentals.

Our staff believes that stocks are 3% overvalued right now, compared to 1% undervalued at the end of 2009. The market as a whole clearly does not possess the incredible value that it did just a short time ago.

But that doesn't mean that stock investors need to give up on finding values. There are still pockets of value among sectors and, of course, in individual stocks. The Business Services sector looks the cheapest right now with a price/fair value ratio of 0.91. Health care has shook off many of the reform blues that dogged it last year, but the sector still looks to be slightly undervalued. The Financial Services sector is also trading at a slight discount as the overhang of the crisis continues to weigh on financial firms.

On the other side, the Hardware sector looks the most overvalued at the moment with a price/fair value ratio of 1.11. Although we're not looking at tech-bubble-like valuations, investors seem to be a little bit too optimistic about the sector's strength. And despite the strong rebound in ad sales, we believe that the Media sector is around 8% overvalued.

Sector Current Price/Fair Value Ratio 52-Week Low 52-Week High Business Services 0.91 0.82 1.11 Health Care 0.94 0.82 0.99 Financial Services 0.96 0.76 1.08 Telecommunications 1.01 0.87 1.05 Industrial Materials 1.02 0.86 1.15 Energy 1.03 0.88 1.07 Utilities 1.04 0.80 1.12 Consumer Services 1.05 0.91 1.18 Consumer Goods 1.05 0.93 1.16 Media 1.08 0.94 1.16 Hardware 1.11 0.95 1.58

 
Looking at the market another way, by competitive advantage, can also reveal opportunities. At the beginning of this rally, lower-quality companies, which have little in the way of competitive advantages (no-moat firms), were outpacing wide-moat companies by a healthy margin.

No-moat firms had been hit harder during the downturn as they had nothing to protect themselves from the vagaries of the economic cycle, so it isn't so surprising that they had such a strong run back.

This trend has continued strongly over the last year. No-moat firms posted a 26% gain over the last 12 months, while wide-moat stocks were only 5.9% higher. We think the market has overshot the mark on no-moat firms. Overall, we think they are about 6% overvalued. On the other hand, wide-moat stocks look to be about 5% undervalued.

Moat Current Price/Fair Value Ratio   1-Year Total Return 3-Year Total Return Wide 0.95   5.91 -3.90 Narrow 1.01   16.67 -3.03 None 1.06   26.20 -2.63

 
Surveying the entire landscape, it seems clear that the easy money has been made. But if you look closely there are some real gems out there. Stay tuned all week for Morningstar's take on the best places to invest in 2011 using mutual funds, stocks, and ETFs.