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Quarter-End Insights

Stock Market Outlook: Pick Your Spots Carefully

Interest-rate fears bring utility and real estate valuations in line, but the broader market still looks fully valued.

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  • After leading the market higher in 2014, utilities and real estate are the worst-performing sectors thus far in 2015. Shifts in the outlook for interest rates are causing stock prices to be far more volatile than long-run fundamentals.
  • Following a comprehensive review of competitive dynamics in the global banking industry, we upgraded our moat ratings for eight banks to wide. Meanwhile, strong performance by the health-care sector has left relatively few opportunities.
  • The S&P 500 is approximately flat since last quarter, leaving stocks fully valued. We encourage investors to consider their risk tolerance, pick their spots carefully, and prepare for subpar market returns over the next five years.

From Euphoria to Panic for Rate-Sensitive Stocks
To see investors’ mood swings when it comes to interest rates, take a look at a three-year chart of  Utilities Select Sector SPDR (XLU) or  iShares US Real Estate (IYR). Both exchange-traded funds zoomed higher in the first half of 2013 as the 10-year Treasury yield fell as low as 1.66%. They collapsed in the second half of 2013 as the 10-year rate surpassed 3.00%. They climbed steadily throughout 2014 as the Treasury yield fell back to 2.17%. And they've been sliding thus far in 2015 as long-term rates creep higher and the Federal Reserve signals its first hike to short-term rates in almost a decade.

We take a long-term view of both cash flows and discount rates, so our fair value estimates haven't moved nearly as much as stock prices. Our discount rates incorporate a 4.5% normalized long-run risk-free rate, which is well above current interest rates. Last quarter, we thought utilities and real estate were overvalued, but with the recent stock price declines, we now see these areas as roughly fairly valued. The median stock in both sectors is trading at a 1%-2% discount to our fair value estimate.

As investors continue to overreact to moves in interest rates, there are a few pockets of opportunity emerging. Within utilities,  Southern Company (SO),  Duke Energy (DUK), and  American Electric Power (AEP) offer generous dividend yields and 8%-10% long-run total return potential. Wide-moat  ITC Holdings (ITC) trades at the steepest discount to fair value since we started covering the stock and offers earnings growth that is double the regulated-utility average. As for real estate, we like the economic defensiveness, long-term growth opportunities, and above-average dividend yields of health-care real estate investment trusts, including  Ventas (VTR) and  HCP (HCP).

Wide-Moat Banks, Overvalued Health Care
On the other end of the spectrum, the health-care sector has been on fire thus far in 2015, up by a double-digit percentage. That follows the pattern of the past three years, during which health care has delivered annual total returns approaching 30%--11 percentage points better than the S&P 500. Speculation about mergers and acquisitions and investors' unbridled enthusiasm for biotechnology deserve much of the credit. The downside is that we now view health care as modestly overvalued, though there are a handful of exceptions such as  Amgen (AMGN) and  Baxter (BAX). Technology and telecom stocks have also been engulfed in M&A rumors, and with both sectors overvalued, we encourage investors to be selective and focus on the fundamentals.

Elsewhere, we have eight new wide-moat banks following a comprehensive review of our moat methodology for the global banking industry. The highest-quality banks are able to establish sustainable competitive advantages through a combination of low costs (cheap deposit funding, superior underwriting, and operational scale) and customer switching costs (most customers would rather avoid the hassle of changing banks). We analyzed 22 global banking systems and found that Australia, Canada, Sweden, and (to a lesser extent) Chile have favorable macroeconomic, regulatory, political, and competitive characteristics that are conducive to moats. As a result, we upgraded our moat ratings for  Toronto-Dominion (TD),  Bank of Nova Scotia (BNS),  Royal Bank Of Canada (RY),  Banco Santander Chile (BSAC),  Banco De Chile (BCH), and  Svenska Handelsbanken (SHB A) to wide from narrow.

Although the U.S. banking system is more challenging--including intense competition and a fragmented regulatory landscape--we found that  Wells Fargo (WFC) and  U.S. Bancorp (USB) also deserved wide moats. Several of these banks are trading at attractive discounts to our fair value estimates, including Toronto-Dominion and U.S. Bancorp.

Flat Market Leaves Stocks Fully Valued
The S&P 500 has barely budged since our last quarterly update, so the market as a whole still looks fairly valued to slightly overvalued. The median stock in Morningstar's coverage universe trades right around our fair value estimate. However, this measure has benefited from lower discount rates in our valuation models, as we now assume investors require a 9% long-run total return from stocks, down from 10% previously.

There can be little question that higher valuations today correspond to lower returns tomorrow. Elevated price/earnings ratios detract from future returns in at least two ways. First, they diminish the benefits of capital allocation: Higher stock prices mean lower dividend yields and less-effective share repurchases. Second, higher valuations increase the likelihood of future P/E multiple contraction, and make it less likely that P/E multiples will expand.

On a price/earnings basis, the S&P 500's valuation remains rich by historical standards. The index was around 2,120 in late June. That implies price/earnings ratios of 19.2 (using trailing-12-month operating earnings), 27.3 (using a 10-year average of inflation-adjusted earnings--the Shiller P/E), or 18.5 (using trailing peak operating earnings). Those measures have been lower 65%, 76%, and 78% of the time since 1989, respectively. Such high valuation levels could be justified--assuming interest rates stay low and profit margins stay high--but we don't see much room for error in today's stock market.

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Matthew Coffina has a position in the following securities mentioned above: ITC, WFC. Find out about Morningstar’s editorial policies.