In the short term, almost anything can happen, but in the long run, returns will likely be lower than recent history, says Morningstar markets editor Jeremy Glaser.
Note: This video is part of Morningstar's January 2015 5-Point Retirement Portfolio Checkup special report.
Jason Stipp: I'm Jason Stipp for Morningstar. Of course, part of your portfolio check-in is reviewing past performance, but you should also set the right expectations for your portfolio looking ahead. Here to help us do that is Morningstar markets editor Jeremy Glaser. Jeremy, thanks for being here.
Jeremy Glaser: You're welcome, Jason.
Stipp: 2014 turned out to be a better year in the stock market than a lot of folks expected, but what about 2015? When we look at market valuations today, what kinds of expectations should we be setting for the future?
Glaser: Well, let's start by looking at those valuations. One of the ways that we look at them here at Morningstar is our price/fair value ratio for the entire market. We arrive at this by our team of equity analysts figuring out the intrinsic value of a number of mainly large- and mid-cap U.S. equities, comparing those fair value estimates to where the market price is, and just seeing how they compare. The median stock that we cover right now is trading at a 4% premium to its intrinsic value.
So, it's overvalued, but only just--not a dramatic overvaluation. And this range of being about fairly valued has been the case for quite some time. Now, one of the big changes that has happened over the last couple of months is the very big divergence in the valuations of different sectors. The energy sector has become quite undervalued; it's trading at 80% of its intrinsic value.
Obviously, with lower oil prices, that's been a big weight on those firms. So, even though some of our fair value estimates have come down, we still think that they are dramatically undervalued in some cases. And other sectors, notably utilities and real estate, look almost 20% overvalued as investors seeking yield have really bid up the price of their shares too much. So, generally, valuations look about fair, but there are definitely some differences among sectors.
<TRANSCRIPT>
Stipp: You said we've seen the market looking overvalued about 4% or so for a little while. I looked back a year ago and we thought the market was about 2% overvalued this time last year. So, how can the market--which was up about 13% last year, the S&P 500--come up so much while the price/fair value ratio didn't really change so much?
Glaser: The simple answer there is that our fair value estimates have increased, and we've seen that for a couple of reasons. The first [reason is] that analysts sometimes just change their opinions on companies because of new news or because of new information. They think that the earnings power of the company and the cash flows that they are going to produce over time have actually increased and that's going to boost their fair value estimates. So, that reason I think makes a lot of sense to most investors. But also even if you didn't expect big changes in the business, you still would see the fair value estimate increase every year due to the time value of money--that the money you have now is worth more than money in the future. So, as you bring those earnings forward a year, discounting by one less year, that's going to increase your fair value estimate. Think about those retained earnings; the intrinsic value of the company is getting bigger, so you'd expect the fair value and intrinsic value to increase there, too. So, between the upgrades that we saw just from fundamental reasons and the upgrades that you see from the time value of money, you do see fair value estimates start to come up a little bit. I think that explains why the price/fair value ratios have looked pretty similar.
Stipp: So, from where we are sitting right now, the median stock does look about 4% overvalued. What does that mean for the expectations I should set for my stock portfolio?
Glaser: Well, this is obviously the important question. I think it's important to note that this median price/fair value number saying we think stocks are 4% overvalued is not a short-term market call. In the short run or even the medium term, almost anything is possible. Stocks could become much more overvalued and stay there; they could become very undervalued and stay there for some time. We really are trying to ask, "What's a reasonable expectation, given current valuations, where we are now, that investors can earn over, say, a 20- or 30-year time horizon--the kind of time horizon that people actually should hold stocks for or that would make sense as part of that broader portfolio?"
Matt Coffina, who is the editor of Morningstar StockInvestor and equity strategist at Morningstar, thinks that somewhere in the 4.5% to 6% range is reasonable for long-term stock returns, given where we are now. And that takes into account what earnings growth is going to look like, dividend yields--because it's a total-return number, what you are going to get paid in dividends. And I think that that strikes me, too, as a very reasonable number for what investors can expect over that long run. But you actually need to be invested over that 20 or 30 years to recognize and to really realize the potential of those gains over time. Trying to time the market by saying, "It's a little bit overvalued now--it's a little bit undervalued now" and coming in and out [of the market], you could really miss some of the big upswings that really could contribute a lot of that return over time and could leave you stuck in the market in periods when maybe stocks aren't doing so well.
It's just very difficult to make those short-term timing decisions. So, for most investors, really sticking with their plan, sticking with that asset allocation is really going to help them achieve those goals, even if that rate's a little bit lower than they are used to over the short term. It's still probably the best strategy versus trying to get the timing exactly right.
Stipp: So, you're saying that getting the long-term average return means you have to hold for the long term. Let's just turn, finally, to talk a little bit about the fixed-income markets. We thought--and a lot of people have thought--that rates would be coming up for a while. That was not the case in 2014. So, sitting here where we are now at the beginning of 2015, given what we think rates might be doing, how should I set expectations for fixed income?
Glaser: Well, if you are going to have more modest expectations on equities, you should probably also have more modest expectations in fixed income--maybe even prepare yourself for the possibility that bonds could lose ground in a situation where interest rates are rising. And that really is the key question. Going into this year, basically everyone thought that interest rates were going nowhere but up, and that just wasn't the case. They actually came in as investors were looking for safe havens, even in a situation where the Fed was very clearly laying the ground to raise rates some time in 2015. And rates will eventually come up; they are not sustainable at these relatively low levels.
Bob Johnson, our director of economic analysis, thinks that we'll be somewhere in the 3% to 3.5% range at the end of 2015. So, when you have those rising rates, that's going to prove to be a headwind for bonds and for bond funds. So, I think investors should be prepared for that. But they should also think closely about why they are holding bonds. It's probably not for absolute return. It's probably because they are using them in a portfolio context as part of an asset allocation. [A balanced portfolio] needs to provide that diversification. Those are the real reasons that they hold them, not just for the big returns that they may have seen when we were in an environment where rates just kept getting lower and lower. So, I think that even if bond returns aren't going to look spectacular, aren't going to replicate the returns we've seen in the past, that's not to say that you shouldn't hold bonds or that bonds aren't still an important part of your portfolio.
Stipp: Setting the right expectations certainly helps us be better investors. Jeremy, thanks for joining me today.
Glaser: You're welcome, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.
 | Morningstar Individual Investor Conference March 21, 2015 | 9:00 a.m. CDT Get a fresh outlook on the market and your investments at our FREE online conference. Join us for a day tailored to help individual investors strengthen their finances by uncovering strategies for building better portfolios from a variety of Morningstar's analysts and noted outside experts.  |
