5 Issues Still on Investors' Plates

Jason Stipp: I'm Jason Stipp for Morningstar and welcome to The Friday Five.

Today we have a special Thanksgiving edition. Morningstar markets editor Jeremy Glaser is here with five things that are on investors' plates.

Jeremy, thanks for joining me.

Jeremy Glaser: Happy Thanksgiving, Jason.

Stipp: There is likely not a lot of food left on investors' plates, but there are still some issues that they are grappling with. The first one is central bank activity, not only here in the U.S. but also abroad.

Glaser: This is one of the big questions, and it really is two separate ones. The first is with the Federal Reserve: when will rates rise in the United States? The Fed seems to be saying that the middle of 2015 is when they are thinking of doing it, and the market very much has that priced in at the moment. I think barring any exceptional changes in the U.S. economic picture, we can expect rates to rise here next year.

But when we look to Europe, the question is a little bit more interesting. Mario Draghi, the head of the ECB, has been talking up the fact that the ECB is ready to have more aggressive asset purchases; they are ready to act to try to get European growth going again and to keep inflation from becoming any lower than its already very low level.

But Draghi faces a lot more structural and political impediments to actually implementing these policies than, say, you have in the U.S. or Japan. So, it will be fascinating to watch if he is actually able to back up his statements with these actions over the next couple of months, and if they have the desired effect.

Stipp: The financial crisis is well in the rearview mirror by now, but housing is still casting some shadows on the economy.

Glaser: Housing has been a disappointment in 2014, and we got more proof of that when the Case-Shiller Index for September came out this week, showing that home prices are increasing but at a slower rate than they were in the previous month, and that's the continuation of a trend.

We have a lot of issues here from affordability to access to credit to a mismatch between the kind of homes that are being built and that are available, and the ones that people want. Those issues continue to hold housing back.

Housing is important to the broader economy, and if can get housing starts back to a more normalized level--even if it's below where it was at the peak before the financial crisis--that really could be a big boost to growth.

We're looking for signs that housing is ready to start turning around. We got glimmers of hope from Home Depot and Lowe's, who, in their earnings calls, said that they are starting to see some more confidence in the housing market, but it might take some time to see that confidence translate into real numbers, into better economic growth, and into a real tailwind for the U.S. economy.

Stipp: Here is one that's causing investors some indigestion: valuations. It looks pretty fully valued across the marketplace, with not a lot of discounts to be found.

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Glaser: I think every investor in every part of the market should be worried about valuations right now. There just aren't that many pockets of value.

Our bottom-up analysis on the equity market shows that the median stock is trading at about 3% over its intrinsic value. If you look at the market in some other ways, it could look even more overvalued. Suffice it to say, there just is no margin of safety. Things are really priced for perfection at the moment. There is not a lot of room for things to go wrong.

So, what should investors do? That's a much more challenging question. Trying to time the market is exceedingly difficult, and as we're seen in the data for years, investors tend not to do a very good job of it. When you look at alternatives, like cash or fixed income, the return prospects in those asset classes don't look all that appealing, either.

I think you could do a lot worse than owning really high-quality companies that you're buying at a fair price and that you intend to hold for a long time. There are a lot worse things in the world than doing that. But if you are, I think you need to keep a few things in mind. First, returns going forward are going to be much lower. Stocks at this level just aren't priced to produce the kind of gaudy equity returns that we've seen over the last couple of years; be prepared for that.

Secondly, there could be a lot more volatility. At this valuation level if something does go wrong, you could see some big sell-offs, and you could see a correction. You need to be prepared both emotionally and financially to weather that.

We think some wide-moat names such as Procter & Gamble and Baxter are the kind of companies that are high quality and that are also selling at fair prices right now.

Stipp: If changes in valuation won't drive a lot of returns going forward, the fundamentals might play more of a role, and earnings growth is one of those. This is something else that investors have been focused on.

Glaser: They have been, and now that the third-quarter earnings season is virtually over, we did see that growth was reasonably good. FactSet, which tracks this, says there was 7.9% earnings growth in the quarter, year-over-year. But this is probably not a sustainable number. It's probably a little bit high, given some of the factors and some of the headwinds that we're about to face. The first of those is slowing growth abroad. The S&P 500 is a U.S. index, but a lot of S&P 500 company earnings come from emerging markets and Europe. As those areas slow down, that's going to be a problem. Also the strong U.S. dollar remains a headwind.

It would be a little bit ironic that as the U.S. economy continues to do better than it has been, U.S. corporate earnings actually might not look quite as strong.

Stipp: Last thing investors are wondering about is oil. That's one of the areas of the market that hasn't done well. Everything else has done pretty well over the last few years. So, what should be on your radar there?

Glaser: This has been a big surprise--how sharply the price of oil has fallen recently. It's being driven by a lot of supply in the market, a drop in demand from a lot of places, particularly China and other emerging markets, and also some concerns about whether Saudi Arabia and OPEC will cut production to try to shore up prices, or are they going to keep producing even at these lower levels?

Lower oil prices have some benefits for the United States' economy. Certainly lower gas prices could mean some good things for consumption and consumer spending. But it has hurt the energy companies. We've seen some big declines in a lot of the energy names. We think the energy sector looks the most undervalued right now at 12% below fair value. That's not an enormous discount, but certainly a discount, which is more than you can say about the rest of the market. And there are some wide-moat names, like Schlumberger in the oil services space, that do look like they are pretty attractively priced now.

Stipp: Jeremy, you've stuffed investors full of great insights. Thanks for joining me today.

Glaser: You're welcome, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.