Our Outlook for the Market
Following a global rally in the first quarter, opportunities are a lot more scarce than they were just three months ago.
Quarter-End Insights
- Our decidedly bullish take three months ago has played out much faster than even we expected, thanks to a tremendous global rally in the first quarter pushing major global markets up 5%-10% or more. As a result, we now see stocks as pretty close to fairly valued, with the market-capitalization-weighted average price/fair-value of stocks under Morningstar coverage at 92%, up from 83% at the end of the year.
- While it is now much easier to find overvalued sectors than undervalued ones, on balance we still see more opportunity for excess return among economically sensitive sectors. Energy and basic materials top our list in terms of sectors trading at the biggest discount to our fair value estimates. Due to what we believe are overblown market concerns regarding regulatory uncertainty, we also think the health-care sector is undervalued.
- Coming off of such a strong quarter in terms of market performance, top-down opportunities are much harder to find. Instead, we encourage investors to focus on companies that are still trading at meaningful discounts to fair value.
At the end of 2011, we pointed to three signs that the U.S. stock market would see a meaningful rally in 2012: pent-up demand for hard goods, solid corporate balance sheets with improving profits, and reasonable earnings multiples.
We continue to believe the U.S. market will benefit from the first two, but after the stunning rally of the first quarter, valuations are not quite as attractive as they were. Not only do the aggregate statistics bear this out, with our coverage universe trading at 92% of fair value and most major world indexes trading at double-digit earnings multiples, but the distribution of our recommendations supports it as well. We currently have an almost equal number of stocks at 5-stars and at 1-star, a stark contrast to late 2008, when more than 60% of our coverage universe was trading at 5-stars. Given that the market has less valuation support than it did three months ago, we wouldn't be surprised to see more volatility in the rest of 2012, with some additional buying opportunities for stocks.
With a mere 62 stocks in our coverage universe trading at 5-star prices, opportunities are a lot more scarce than they were just three months ago. That said, we're still finding opportunities, particularly among more economically sensitive sectors. The basic materials and energy sectors are trading at 87% of fair value, lower than any other sector. On the high end, real estate looks more than 10% overvalued to us, at 111% of fair value, although the biggest rallies in the first quarter were in technology and financial services. Dig a little deeper, and you find industries within basic materials and energy that are downright cheap, with aluminum at 60% of fair value, steel at 63%, and oil/gas equipment & services at 75% of fair value.
All else equal, we're much more interested in allocating cash to stocks than bonds in this environment. Yields on corporate bonds could hardly be lower, and in fact, we expect this multiyear rally in bonds to finally begin to reverse later this year. As the U.S. economy continues to recover, we believe investors will be much better off in stocks than in bonds.
In Europe, the picture has improved, albeit temporarily. The European Central Bank has managed to avert a liquidity crisis, but as my colleague Dave Sekera comments in our bond market outlook, the underlying solvency problems are far from resolved. The ECB has certainly bought some time, though, and the market has rewarded this improvement. That said, we still think there are opportunities to invest in undervalued European companies such as wide-moat firm Novartis (NVS), a major global pharmaceutical company trading at a 20% discount to our fair value estimate. For those with a little more appetite for risk, narrow-moat steel firm ArcelorMittal (MT) is trading at just 40% of what we think it's worth due to heavy exposure to the European economy.
As I write this, I'm on my way back to the U.S. from Australia, where the economic picture is quite different. Ask any Aussie, and you will quickly learn that the country is in the midst of a "two-speed economy." Specifically, while the resources sector is booming, the rest of the economy is showing meaningful signs of weakness. There is no doubt that China's future plays a critical role in keeping the Australian economy afloat, and it can have a meaningful impact on many parts of the global economy. There's also little doubt that China's industrial boom is showing signs of slowing. So far, China has proven adept at managing this slowdown in a relatively orderly fashion. As long as that continues, we think the global economy can still slowly recover, but a big slowdown in Chinese economic growth is the biggest risk we think markets face today.
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