Our Outlook for the Market
As the market struggles under clouds of uncertainty, 10 out of 11 sectors are now trading at levels that we consider undervalued or cheap.
Quarter-End Insights
- Uncertainty regarding the viability of the European Union brought about by sovereign debt crises there has lowered the aggregate value of the U.S. market vis-a-vis Morningstar's fair value estimates. At the close of the third quarter of 2011, the market-capitalization-weighted average price/fair-value ratio of stocks under Morningstar coverage stands at an undervalued 78%.
- The cheapest sectors consist of the usual suspects--the economically sensitive financial services, energy, industrials, and basic materials sectors--where some attractive businesses are selling at a substantial discount.
- We believe uncertainty and equity market volatility will continue into the fourth quarter as European states struggle to balance the economic imperatives of their polities with their commitment to currency union. If uncertainty regarding the viability of the European Union deepens or if a determined and credible solution to the eurozone's structural weaknesses is not found soon, the impacts to global trade will likely be material over the short- to medium-term.
- Companies in the U.S. are generally well-positioned to survive a downturn, having greatly improved the condition of their balance sheets and taken steps to increase profitability since the 2008-2009 downturn.
What a difference a quarter makes! In contrast to a fully valued market at the end of the second quarter, as we near Sept. 30, 10 out of 11 sectors are trading at price/fair-value ratios that we consider undervalued or cheap. Only consumer defensive stocks (where our team especially likes Avon and PepsiCo (PEP)) are trading at a fully valued average price/fair-value ratio of 96%. Overall, stocks under Morningstar coverage are trading at a cheap 78%, though on an uncertainty-weighted basis, that ratio is slightly higher, implying an average star rating of closer to 4--undervalued but just shy of a Consider Buy price.
Investors looking for bargains and willing to tolerate some volatility should look to financial services, energy, industrials, and basic materials sectors, all of which are trading at price/fair-value ratios of less than 80%. A few of our teams' top picks in these sectors are Transocean (RIG), ArcelorMittal (MT), and Ford (F). Please refer to the detailed sector reports for more specifics.
For more risk-averse investors, the market turmoil has brought defensive-oriented health-care names within reach of those searching for value. Our top picks in health care include Medtronic (MDT), Abbott Labs (ABT), and Covidien . Please see Thursday's sector outlook report for health care for more details about these companies and their operating environment.
The Macro Backdrop
In our last quarterly update in June, we raised the possibility of a period of "inflationary deflation" and indeed, several of our teams have reported this phenomenon to a greater or lesser extent. The inflationary part of the equation could be seen in rising prices in everything from agricultural commodities (due to such factors as Russian wheat shortages and interruptions to cocoa production) to luxury goods (as premium brands realized their market would bear higher selling prices) to manufactured goods (thanks to wage pressures in China). At the same time, persistently high un- and underemployment in the U.S. has contributed to slower personal income growth and a tendency toward wage deflation. After showing some signs of life early on in the quarter, housing prices as tracked by the S&P Case-Shiller Index have started moving down again, reinforcing the deflationary side of the trend.
The biggest macroeconomic stories of the third quarter had large political components. As we predicted in our last quarterly update, the European debt and fiscal crises have continued and deepened over the past three months to the extent that more and more observers are beginning to openly question the political viability of the European Union. The Greeks long for the ability to devalue their way to export prosperity that an independent Drachma would grant them while chafing at EU-imposed austerity measures; German voters grumble about picking up the tab for Greek profligacy. Readers who took our advice at the end of last quarter and shifted exposure in the financial sector from money center banks into regional ones spectacularly outperformed. As we had thought, regional banks have much less exposure to European debt issues than do money center banks and correspondingly did comparably better the more that Europe melted down.
In the U.S., what had long been considered a procedural matter of voting an increase in the debt ceiling limit to fund spending already approved by Congress turned into a full-blown political battle. The showdown ended up nearly halting government services and prompted the first agency downgrade of U.S. sovereign debt in history. The ugly political wrangling, combined with high levels of unemployment and an overall tepid recovery contributed to a drop in consumer confidence to 2009 crisis levels and set the ball rolling on what is feeling more and more like an equity bear market.
The one bright spot amid the gloom and concern has been falling energy prices. Morningstar director of economic analysis Robert Johnson notes that gasoline prices have fallen for three consecutive months. We had predicted this occurrence in our previous quarterly update on the theory that tensions in the Arab world during the spring would wilt under the hot summer sun. This was perhaps the impetus, but the trend has been exacerbated recently by uncertainty in Europe and weakening economic readings in the U.S. prompting concerns of a global slowdown. Whatever the reason, lowered prices at the pump have indeed allowed less affluent shoppers to benefit from the fuel tax "rebate" and keep up with steady 3%-5% per annum growth in spending--a dynamic that we predicted last June.
Looking Ahead
After having read through the most recent academic paper from professors Reinhart and Rogoff (the world's leading experts on financial crises), this observer has come to believe that the developed world is in for a long slog before we begin to see a return to robust economic growth. Reinhart and Rogoff note that high levels of systematic indebtedness (as are found in the OECD economies now) are historically associated with slower economic growth, and they opine convincingly that the present round of indebtedness will take longer to resolve itself due to the degree to which the global economy is tightly interconnected.
We believe there will have to be some combination of higher levels of taxation and greater degrees of governmental austerity across the OECD countries in order to clear the debt burden accrued over the last decade or longer. These steps, while necessary in the long run, imply a tougher row for both consumers and corporations to hoe. Higher taxes and lingering high unemployment levels mean wage pressures on those employed, and uncertainty regarding the future status of societal safety net programs as a part of austerity measures mean subdued spending from those on fixed incomes or those who are marginally engaged in the economy. Morningstar economist Johnson points out that the two greatest contributors to U.S. GDP growth since the 2008-2009 downturn were the consumer and exports. We believe that consumer spending is likely to come under pressure for the reasons mentioned above, and also fear that a breakup or partial breakup of the eurozone or a dragging on of uncertainty over viable solutions to its structural problems could well crimp U.S. exports.
While these may sound like gloomy pronouncements, we must also note that thanks to steps taken during the recent downturn and an increased economic exposure to more rapidly expanding developing economies, many U.S. companies find themselves in enviable positions in terms of profitability and balance sheet strength. Profit margins are running at all-time highs, and the aggregate amount of cash on U.S. corporate balance sheets amounts to over $2 trillion--a record amount. This financial strength, combined with low interest rates for long-term debt, will likely prompt merger-and-acquisition activity as well as higher levels of stock buybacks in the medium term. In addition, the combination of nicely cash-cushioned balance sheets with market irrationality has led to some excellent opportunities in the credit market. Morningstar bond strategist David Sekara has written extensively about bond mispricings in the credit sector summary and particularly likes the credits of Symantec (ticker: SYMC; rating A+), Darden Restaurants (ticker: DRI; rating BBB+), and Lorillard (ticker: LO; rating BBB).
In the shorter term, we believe that the next quarter will likely see an amelioration of inflationary pressures, thanks mainly to a decrease in commodity prices. However, considering the theme of inflationary deflation, an amelioration of the former (inflation) will end up meaning an exacerbation of the latter (deflation). Certainly, companies that have attempted to push through price increases lately have been greeted by lower sales, and we believe this is likely to become a trend. A well-publicized recent example of this dynamic has been a stock that our team has long considered overvalued-- Netflix (NFLX)--but our consumer team has also noted reduced clothing sales tied to price increases in that market.
Despite our belief that commodity prices will dip in the short term, our energy team is standing by its prediction for a long-run average price for oil in the $100 per barrel range based on evidence that emerging markets continue to drive robust demand while supply appears stretched. They also believe we are on the cusp of increased domestic natural gas prices thanks to regulatory changes making it more expensive to burn coal for energy generation. An increase in the price of natural gas will not only help companies involved in the exploration and production of the commodity, such as energy team favorite Ultra Petroleum , but also utilities, which are able to pass through natural gas price increases along to power customers whether their installations burn natural gas or not. Our utility team likes Midwest nuclear giant Exelon (EXC) as a large-cap name and Ormat (ORA), an innovator in the field of finding and exploiting geothermal energy, as a small-cap one.
In general, we believe that larger companies with stronger moats (durable competitive advantages) will better weather the perfect storm of deleveraging, austerity, and a consumer struggling to keep up. If and when equity markets experience large drops in the coming quarter, the best strategy is to keep one's eyes open for wide-moat, low-uncertainty stocks trading at a material discount to our fair value estimates.
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