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Quarter-End Insights

Stock Market Outlook: Investors Must Dig Deeper in an Overvalued Market

In a market leaning toward the overvalued side, stock-picking is key, and opportunities can still be found.

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  • The median valuation of our coverage universe continues to tick up, standing at 104% of fair value going into the third quarter. 
  • In a market leaning toward the overvalued side, stock-picking is key, although investors must dig deeper to unearth buying opportunities. There are still a number of high-quality businesses trading at a reasonable margin of safety. 
  • On a global scale, firms that our analysts cover in Asia-Pacific now look to be the most undervalued, reversing the region's most overvalued position at this time last year. Conversely, North America and Europe look to be the most overvalued.

 

If You Sold in May and Went Away, You Missed Quite a Rally in the U.S.
The old adage suggests to stash your cash in the mattress in May, but it appears the bull U.S. equity market has no respect for the calendar, with the S&P returning 2.1% in the month of May and rewarding investors who were along for the ride.

European markets didn't fare quite as well, as low economic growth and resilient unemployment continues to plague the continent. However, no matter how you slice it by geography, investors have been rewarded handsomely year to date, despite lingering concerns regarding the overall pace of recovery in the developed-world economies and worries about the strength of emerging markets, particularly China. The world bank recently cut its global forecast for growth, citing weakness in the U.S., global political instability, and deceleration in emerging markets, but as corporate profit margins continue to expand, the bull market appears to be unstoppable.

Stock-Picking Is Critical in This Market
Being bottom-up stock pickers, we at Morningstar find it challenging to recommend many equities amid a strong market rally. Certainly, there are a number of great businesses out there that some would consider owning no matter where the markets go, but we caution that "buy and hold" isn't the same as "buy and forget." It is critical for investors to examine their holdings thoroughly and frequently, no matter how safe those positions appear to be, because even the best companies could become overvalued. "Best company" isn't always equal to "best investment," and to paraphrase Warren Buffett, being fearful rather than "fearful of missing out" sometimes is a prudent strategy. 

That said, even in this current bull run, we don't consider stocks to be a terrible place for investment. Our aggregate median price/fair value ratio is a few percentage points over 1, suggesting slight but not egregious overvaluation. However, this ratio has crept up slightly over the past few quarters; better-than-expected earnings so far have moved our valuations upward but not at the pace of the overall market. Sector-by-sector aggregate analysis shows quite divergent paths, however. Technology stocks are still on a tear, trading at a notable premium to our valuations, while energy, basic materials, and financial services sectors are roughly fairly valued.

Currently, we have less faith in the outlook for returns in the technology sector, which faces a much higher degree of disruptive innovation risk over the long run and even higher current valuations. However, there are pockets of value for patient investors. In particular, we believe that the international telecom and domestic cell tower industries offer more appealing valuations. In general, we would prefer a wider margin of safety in technology and are quick to gravitate toward firms with established economic moats, which might be in a better relative position to withstand near-term revenue and operating margin volatility.

The industrials, health-care, and consumer cyclical sectors also look quite pricey right now. Of particular note is the outlook for retailers, where we have some concerns about profitability in upcoming second-quarter results. Many stores' sales were negatively affected in the first quarter by poor weather conditions throughout the country, and a need to liquidate remaining inventory could invite price discounting, hampering gross margins. 

Aggregate analysis doesn't tell you the whole story about where we see the most attractive opportunities. Individual stock-picking is critical, in our view, to successful investment, and there are still wonderful businesses out there that are cheap. This isn't 2008, when nearly half of our stocks under coverage were trading in 5-star territory, but we still have wide moat companies such as  eBay (EBAY),  Core Laboratories (CLB),  Express Scripts (ESRX), and even  Berkshire Hathaway (BRK.A)/(BRK.B) trading at meaningful discounts to our fair value estimates. 

Cast Your Net Globally
It isn't always easy for U.S. investors to get out of their comfort zones of investing domestically, but in these days of an increasingly globalized stock market, the foreign domicile alone shouldn't be a hindrance to selecting stocks. After all, we are seeing massive trends toward shifting domiciles overseas to avoid U.S. taxation policies, so looking at U.S. companies only would result in significant missed opportunities. There are wonderful businesses that exist across all the geographies, and with most sophisticated investors casting a rather wide global net, we tend to do the same when identifying the best companies as well as stock ideas. 

On average, the U.S. market is trading at the steepest premium to our valuation relative to the rest of the world (106%), so when broadly looking for ideas, emerging markets are fairly attractive at this point. Once again, we don't advocate buying every equity in geographies outside the United States, but the market rally has definitely moved valuations upward in the U.S. while the rest of the world has lagged. The most attractive areas are currently Latin America (92% of fair value estimate) and APAC/Australia-New Zealand (all trading at par). Canada and Europe are modestly overvalued (102% and 104%, respectively).

Please see our detailed take on each sector and top picks in the reports that follow.

More Quarter-End Outlook Reports

Alex Morozov does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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