Our Outlook for the Market
Regional banks, 'sin' stocks, and an energy major are worth a look amid a market that's relatively fully valued.
Quarter-End Insights
- The market looks generally fully valued, though our energy team's recently increased assumptions regarding long-term future oil prices make the energy sector seem slightly undervalued. This undervaluation is affected by the huge market capitalization of ExxonMobil, which is trading at a fairly significant discount to its fair value estimate.
- Reductions of political tensions in the Middle East look to help push oil prices to levels slightly lower than those seen in the spring. This, in turn, will have a positive effect on U.S. consumers, who will be able to use the money they save at the pump on retail spending.
- The European debt and fiscal crisis is likely to drag on, providing headline risk for European and U.S. banking sectors. These issues will have a greater effect upon U.S. money center banks than regional ones; regional banks may be helped by an increase in real estate prices, which our industrials team is predicting.
Looking at the stocks under our coverage, we do not see large dislocations between market prices and our fair value estimates. All but one of our 11 sectors are fully valued to a greater (real estate) or lesser (financial services) extent.
The lone undervalued sector--energy--is only slightly so, and in fact this undervaluation is an artifact of the enormous market capitalization of ExxonMobil (XOM) on our market capitalization-weighted figures. For those of you interested in broad energy sector exposure, Exxon--which has supplemented its strength in oil production with purchases of natural gas production capacity--is an interesting name trading at a cheap uncertainty-adjusted price-to-fair-value ratio of 80%.
Overall, stocks under our coverage are trading at a nominal price-to-fair-value ratio of 89%. When adjusted to account for differences in uncertainty ratings, that ratio moves up to 91%--implying a market that is relatively fully valued.
The Macro Backdrop
In our last quarterly update in March, we focused on inflationary pressures and their effects on companies. Indeed, as the events of the "Arab Spring" unfolded, oil prices rose from the $85 per barrel level to the $115 per barrel level. However, as the Arab Spring turns to a hot summer, and protesters become less willing to take to the streets to brave both bullets and the sun, we believe that short term, oil prices are likely to drop nearer to our long-term price forecast. Morningstar's director of economic research Bob Johnson believes this dynamic will effectively provide an "oil tax" rebate to the U.S. consumer, who will keep spending.
Meanwhile, another of the root causes of inflationary pressures--namely China, with its seemingly inexhaustible demand for basic materials--has begun to show some friction between a government keen to cool speculation and a market that is running hot. Any slowdown in China has the potential to send commodity prices down and take the edge off the inflationary pressures in the United States and the rest of the developed world. Morningstar's senior equity analyst specializing in China research, Dan Su, believes that while signs of excesses in China (especially in construction projects) exist, the situation is more complex. Government policies designed to restrain real estate speculation seem to be working, but China does have a bona fide need for a great deal more infrastructure improvements. Short term, we do not foresee an end to the China/commodities story, though the government will need to show great restraint and wisdom longer term to sustainably develop its potentially enormous economy.
Sovereign Spillovers
We believe that the European debt and fiscal crisis has further to run. Our analyst in charge of foreign banks, Erin Davis, sees European stress tests--due to come out in July--as a catalyst for further drops in the European banking sector.
U.S. money center banks have counterparty exposure to these large European banks through securities markets and thus are the most likely to start sneezing when and if their European cousins catch a cold. As such, investors wanting banking industry exposure may do well to shift their portfolio allocations away from the U.S. money center banks and toward the regionals. Regional banks are net investors of their clients' funds (in contrast with money center banks, which scramble every day for overnight loans in order to meet capital requirements), and thus regionals will be less exposed to sudden drops in liquidity, which might come about due to frightening European headlines or sovereign defaults. In addition, our banking team believes that loan demand and credit quality for regionals is on an upswing, which may lead to increased M&A activity. Our regional banking analyst, Michael Kon, likes East West Bancorp (EWBC), City National , Regions Financial (RF), and Capital One (COF).
One of the regional banks' traditional business performance drivers is local real estate. Morningstar director of equity industrials research, Eric Landry, has been tracking the listing prices of homes, and a recent uptick in this leading indicator makes him think chances are good we will see an increase in U.S. housing prices as tracked by the Case-Schiller Index over the next few months. Not only would this be welcome news for the regionals' loan books, it would offer a boost of confidence to the broader market as well. In housing-related stocks, Landry likes St. Joe Corporation (JOE) and Masco (MAS). Our consumer team likes wide-moat home improvement retailer Home Depot (HD) and its smaller competitor Lowe's (LOW); the success of both is integrally tied to the health of the real estate market.
Deflationary Inflation?
While our opening point, and the entirety of last quarter's update, focused on inflationary pressures, one cannot deny that deflationary pressures exist side-by-side with the inflationary trend. "Deflationary inflation" might cause some cognitive dissonance, but considering the continuing weak employment numbers and U.S. real estate prices that have thus far failed to bounce despite two quantitative easing programs' worth of stimulus, this observer believes it is a conceptual framework worth consideration.
While the U.S. consumer seems to be able to hold out for yet another quarter, the widespread issues of un- and underemployment, combined with consumers' inability and/or unwillingness to pull cash out of their real estate to the extent they have in the past, may mean more restrained spending in the future.
For those worried about these issues longer term, our director of equity research in the consumer sector, R.J. Hottovy, suggests looking for value in names like Procter & Gamble (PG) and Wal-Mart (WMT), both of which have sustainable, structural competitive advantages (or, in Morningstar parlance, "economic moats") due to their size and scale. "Sin" stocks may benefit as well, and Hottovy recommends names such as Imperial Tobacco (IMT) and Diageo (DEO), as well as that paragon of relieving consumers of disposable income-- Las Vegas Sands (LVS).
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