Stock ETFs Worth Sticking Around For

Paul Justice: How much yield do you really need?

Hi, there. I'm Paul Justice, director of ETF Research at Morningstar.

Investors over the last year have really been fleeing out of equity markets and putting more funds into bond funds at a time when interest rates are really near historic lows.

In the ETF space, we saw over $120 billion come into ETFs, but $53 billion of that went into fixed-income products. In the mutual fund landscape, the story is even more stark. What we saw is over a $100 billion withdrawal from equity funds, and $170 billion went into mutual funds in the fixed-income space.

To me this may be a disturbing trend. While we're proponents of getting your asset allocation right, your stock/bond mix correct, we think that people are afraid of equity markets at this point in time--a fear that may not be justified to this extent.

To talk a little bit about equity valuation as we see it in the broader market space, I have Mike Rawson joining me, one of our ETF analysts who covers our broader index funds.

Thanks for joining me, Mike.

Mike Rawson: Thanks for having me, Paul.

Justice: So, with investors fleeing over to bonds from stocks, and potentially in a fear-driven state, do you think that this is a rational move at this point in time? What do you think the S&P 500 holds for people today?

Rawson: Well, we think the S&P 500 is fairly attractive on a number of valuation metrics. First of all, the valuation metrics we value most highly here at Morningstar is our Morningstar fair value estimate, which is driven by the equity analysts who cover 465 out of the 500 stocks in the S&P 500.

Justice: So, we've got it covered?

Rawson: Yes. Each of these analysts build discounted cash flow models on the stocks that they cover, and what we can do, then, is we can aggregate those fair value estimates on the individual stocks up to the index level and get a valuation for the index.

So, for the S&P 500 right now, they see the S&P 500 trading at a fair value of around 1,500. The current price is about 1,350, so that leads to a price-to-fair of about 90%, which is somewhat attractive.

Justice: So, roughly fairly valued, if we take it within a standard deviation of what people would say. Maybe slightly attractive.

Rawson: Sure.

Justice: So, that's one way to go about it. It's been a very effective way to go about it, too, over the last seven years.

What other metrics are you looking at on the S&P 500--perhaps from a top-down view or more of a fundamental basis?

Rawson: Well, there are a couple of other commonly used metrics, such as price-to-forward-earnings. So, if you look at Wall Street consensus earnings estimates for 2012, we're looking at about $105 per share on the S&P 500. That puts the price-to-forward-earnings ratio on the S&P 500 at about 13 times, which again is moderately attractive--maybe not a screaming buy, but still not overvalued by any means.

Justice: Now, if we smooth it out a little bit, there is a common way, the Shiller P/E ratio, which kind of smoothes the earnings over time. Can you talk a little bit about that?

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Rawson: Well, the Shiller P/E takes a 10-year average of earnings. Now, on that basis, the S&P 500 doesn't look quite so attractive. The Shiller P/E right now is about 21 times, whereas over the long term it's been around 16 times. So, right now, based on the Shiller P/E, the market is not as attractive.

But I think there are some other reasons why the S&P 500 might look attractive. You've got dividend yields on the S&P 500 of around 2.1%. That's above the 10-year bond yield of 1.8%. So, you mentioned investors going into bonds. You're getting about a 1.8% return on those 10-year Treasury bonds, whereas you can get a higher yield through dividends in the S&P 500.

Justice: So, I think realistically, investors should expect probably a lower annual return, say, for the next decade than they experienced over the last, well, 25 years. The last decade wasn't so great. But get your expectations in check and make sure you've got that mix correct?

Rawson: Absolutely.

Justice: Now, within equities, not everybody likes to buy the S&P 500. Do we see any, gradients of valuation; places where people should be shifting at this point in time in a broader sense?

Rawson: Sure. Well, if we look at the Morningstar Style Box, you definitely see a preference for large-cap and value stocks. In fact, large-cap value is trading at a price to fair value of around 86%, large-cap growth around 90% of fair value ...

Justice: ... And lower is better in this case.

Rawson: Lower is better, so the lower the price to fair value, the more attractive the sector is. And so we see that value is more attractive than growth.

On a size perspective, our analysts don't cover enough stocks to get a price-to-fair-value on small-cap stocks, but we see a trend if you look at mega-cap, large-cap, and then mid-cap stocks, the preference is definitely for mega-cap, then large-cap, and then those mid-cap stocks actually look fully valued, trading at a price to fair value of about 100%.

Justice: So we've got a preference for that upper left hand corner of the style box at this point in time.

Rawson: Absolutely.

Justice: Now, if we look at it through a different lens, say, the sector lens, what do you see as some potentially undervalued sectors at this point, and where would be some areas of caution?

Rawson: Sure. Well, hands down, the most attractive sector is energy, and one of the ETFs that we like in the energy space is the Market Vectors Oil Services ETF, symbol is OIH. This is an ETF which focuses ... it's really pretty concentrated on oil and equipment services companies. In fact, 20% of the fund is invested in Schlumberger, which has a 4-star rating and has a wide economic moat. So, energy is definitely one of the most attractive sectors from a sector standpoint.

A couple of other sectors we like--not so much just based purely on valuation, but also on earnings growth potential--are technology and industrials. Whereas the S&P 500 in the first quarter had about 7% earnings growth year-over-year, industrials and technology both grew at double-digit rates, in the teens percentage rates, in terms of earnings growth.

So, for industrials, we like the mega-cap industrials that you can get through an ETF such as the Industrials Select Sector SPDR ETF, symbol is XLI, and in technology we like the low-cost, broad, diversified technology ETF Vanguard Information Technology, the symbol there is VGT.

Justice: And areas of caution that you don't like at this point in time?

Rawson: Well, there are two segments of the market that we feel are fully valued, and those are utilities and consumer staples. Those traditionally are defensive sectors, sectors that people would turn to for yield. You mentioned at the onset that investors were looking for yield. Both of these sectors are trading in line with their fair value, so at about 100% price-to-fair-value. So, we don't see much upside in those sectors.

Justice: Sure, and they might be interest-rate sensitive, too, if rates start going up.

Rawson: Absolutely. And finally, another way to look at those sectors would be on a P/E basis. Both of those sectors are trading at a price-to-earnings ratio above the S&P 500, despite the fact that they have lower earnings growth potential than the S&P.

Justice: If any growth whatsoever.

Rawson: Exactly.

Justice: Well, thanks for those insights. Hopefully, this isn't acting like a big bull call for stocks all the way, but certainly warrants some caution for people who are getting overweight in bonds at this point in time.

Thanks for joining me, Mike, and thank you for joining us.