Fed Fears Not Creating Many Opportunities

It was a rough week for the markets. Instead of soothing investors Wednesday, Fed chairman Ben Bernanke's press conference sent stocks, bonds, and gold into a tailspin. 

The broad-based Morningstar U.S. market index fell 2.2% last week, the yield on the 10-year Treasury rose to 2.5%, and  SPDR Gold Shares (GLD) lost 7% since Monday. The sell-off may have some investors looking to indiscriminately buy on the dip, but given that valuations are still full, it remains as important as ever to look before you leap.

The proximate cause of the sell-off was fear of what will happen when the Fed starts taking its foot off the gas pedal and begins to taper its purchase of mortgage-backed securities. Bernanke's statements that the tapering could begin later this year if economic conditions continue to improve was a message that came sooner than many had expected. The worry is that when the Fed stops aggressively buying mortgage-backeds and other bonds, it could lead to higher rates which would slow an already fairly tepid recovery. These are legitimate fears. The Fed has been one of the most effective institutions throughout the financial crisis; it has deployed a large number of unconventional policies to help keep the economy moving and has been aggressive in setting expectations that policy is going to be loose for quite some time. It's understandable that the market is skittish now that the central bank seems more focused on its eventual exit than on further easing

However, as Morningstar's Bob Johnson discussed earlier this week, those fears may be somewhat overblown. He sees the Fed as having been an important factor in getting the economy back on track but also says economic fundamentals are now strong enough to survive the tapering. Furthermore, if the economy does take a step back after the tapering, inflation is low enough right now that the Fed will be able to step back into the marketplace if need be. These moves are really the first of many steps toward the normalization of monetary policy. The process will likely be bumpy, but it has to happen eventually and represents an important step toward finally stepping out from the shadow of the financial crisis.

No matter your view on what impact the Fed's exit will have on the economy or the stock market, it's undeniable that last week's news created volatility the likes of which we haven't seen in some time. But is a declining market creating any compelling equity opportunities? A few, but not very many. Our team of equity analysts still think that stocks are fairly valued. The median price/fair value ratio of stocks in Morningstar's coverage universe now stands at 0.97. This is a far cry from the approximately 20% discount our analysts saw during other periods of volatility, such as in August 2011 during the height of the debt-ceiling debate and the European debt crisis.

This doesn't mean there aren't any values left, but investors looking to buy on the dip need to be quite selective. To find some good candidates to put money to work in today's market, we used Morningstar's  Premium Stock Screener. We started by looking for companies with Morningstar Ratings for stocks of 4 or 5 stars to find undervalued securities. We also limited the screen to wide-moat, low-uncertainty firms. These companies have solid competitive advantages and underlying business strength that will likely be able to withstand any economic blowback from the Fed's tapering. And low fair value uncertainty ratings mean that our analysts think there is a relatively narrow band of possible outcomes for these firms. Below are three firms that passed the screen. Run it for yourself by  clicking here.

 Johnson & Johnson (JNJ)

From the  Premium Analyst Report:
Johnson & Johnson stands alone as a leader across the major health-care industries. The company maintains a diverse revenue base, a robust research pipeline, and exceptional cash flow generation that together create a wide economic moat.

Johnson & Johnson's healthy free cash flow (operating cash flow less capital expenditures) is more than 20% of sales. Strong cash generation has enabled the firm to increase its dividend for the past 50 years, and we expect this to continue. It also allows Johnson & Johnson to take advantage of acquisition opportunities that will augment growth.

 Coca-Cola (KO)

From the  Premium Analyst Report:
Coca-Cola's wide economic moat is bolstered by its bevy of powerhouse brands and its extensive distribution network, which enables the company to deliver its products to consumers in more than 200 countries. While declining consumption of carbonated beverages in North America will serve as a near-term headwind for Coke, we believe international markets will provide plenty of growth opportunities in the long term. Absent any strategic missteps, we view Coca-Cola as a safe haven in an uncertain economic environment, given that it has one of the widest moats in our consumer coverage universe.

 Enbridge (ENB)

From the  Premium Analyst Report:
Enbridge is uniquely positioned as one of a handful of experienced midstream companies with the expertise, scale, access to capital, and geographic reach to successfully grow its pipeline transportation business. It has the capability to do this through the simultaneous execution of multiple projects, spanning several jurisdictions. This includes a portfolio of opportunities that are developing from the explosive growth in liquids in Alberta's oil sands, the Bakken, and overall volume growth flowing into the major oil hub of Cushing, Okla. In addition to its liquids opportunities are growth opportunities in its natural gas, distribution, and electricity business units.

All data as of June 21.