Stock Market Outlook: A Year of Contradictions

• The S&P 500 has rallied since bottoming in mid-February and is back within a few points of its all-time high. As a result, our analysts once again don't see much value in the market as a whole.
• This has been a year of contradictions, with the market's best-performing sectors coming from opposite ends of the risk spectrum: utilities and consumer staples on the defensive side and energy and basic materials on the cyclical side. Our analysts find all of these sectors overvalued.
• While no sectors are deeply undervalued, we're finding the best opportunities among out-of-favor financial-services, consumer cyclical, and healthcare stocks.

Interest Rates, Economic Fears, and TINA After a rough start to the year--the S&P 500 fell more than 11% in the first six weeks of 2016--the market abruptly reversed course. Although the "Brexit" vote caused volatility in recent days, we're now back within a few percent of the all-time high, and our analysts find the average stock in our coverage universe to be trading close to fair value.

The fears that had gripped investors early in the year haven't exactly gone away: Economic growth is still sluggish to nonexistent around the world, corporate earnings are moving in the wrong direction, and valuations remain well above historic norms. However, investors appear to be coalescing around a worldview that's even gained its own endearing acronym: TINA, as in "there is no alternative" to stocks.

Defying previous expectations for multiple Federal Reserve interest-rate increases this year, long-term Treasury yields have drifted lower since the beginning of 2016. At first, this was seen as reason for concern. If the Fed isn't in a position to raise rates now--seven years into the recovery and with unemployment at just 4.7%--then there must be something seriously wrong with our economy.

But TINA thinking is overtaking economic jitters. Sure, corporate earnings have been terrible. And sure, the S&P 500 was recently trading for 21 times trailing 12-month operating earnings--a level not seen since the cyclically depressed earnings of 2009. But investors have to put their money somewhere. Even overvalued stocks are better than a 10-year Treasury yielding 1.5%, right?

Commodity Price Rebound: Real or Illusory? The drop in interest rates explains half of the year's best-performing sectors: Defensive stocks like utilities, REITs, and consumer staples--widely viewed as the most bondlike stocks--have been on a tear. The other half of the story can largely be attributed to a rebound in commodity prices ranging from oil to iron ore. Commodity prices are still well below their levels of a couple of years ago, but they're well above the recent lows, giving investors hope that the worst may be behind us. As a result, energy and basic materials have joined the most defensive sectors in leading the market higher in 2016--one of the stranger correlations you'll see.

Unfortunately, our analysts believe investors have already overreacted to the runup in commodity prices. This is especially true for industrial commodities, where our bearish view on China's infrastructure spending causes us to believe that current commodity prices are unsustainable. As of May 31, energy and basic materials were both trading more than 25% above our market-cap-weighted average fair value estimates, making them the most expensive sectors by far. Long-suffering commodity investors may want to take this relief rally as a chance to run for the exits.

Defensive, interest-rate-sensitive sectors also look overvalued to our analysts, though not to the same extent as energy and basic materials. We recently pegged utilities' market-cap-weighted average price/fair value ratio at 1.07 and consumer defensive's price/fair value at 1.04. These companies may be insulated from economic ups and downs, but many of them struggle to deliver attractive revenue and earnings growth.

Financial Services, Consumer Cyclical, and Healthcare Offer Better Values No sector looks obviously cheap in this fully valued market, but we're finding relatively better values among beaten-down financial-services, consumer cyclical, and healthcare stocks. These sectors carried average price/fair value ratios of 0.88, 0.93, and 0.95, respectively, as of May 31.

Diminishing expectations for interest rates have been a significant headwind for financial services. Banks have seen steady erosion in their net interest margins, and they were counting on Federal Reserve rate hikes to reverse this situation. For valuation purposes, our analysts still assume a long-term, normalized 10-year Treasury yield around 4.0%-4.5%. In a discounted cash flow framework, this long-term assumption matters more than the path taken to get there.

Within consumer cyclical, we believe investors have overreacted to the challenges facing apparel retailers. E-commerce poses a serious long-term threat, but there are also cyclical elements to recent weak apparel results, including excess inventory and a lack of new fashion trends. We think off-price retailers and branded apparel manufacturers, especially those selling basic replenishment goods like undergarments, are best positioned for the long run. Traditional retailers and department stores look most at risk.

As for healthcare, we see improved pipeline productivity driving growth at pharmaceutical and biotechnology firms. Despite political rhetoric around drug pricing, we expect pricing power to remain strong as companies deliver innovative new therapies in areas of unmet medical need, such as oncology and immunology. New immuno-oncology drugs are reaching the market in half the time of drugs developed a decade ago thanks to both scientific advancements and a more accommodative regulatory environment.

More Quarter-End Insights

Credit Markets: Snap-Back Rally Stalled

Basic Materials: Recent Commodity Rallies Leave Few Opportunities

Consumer Cyclical: Market Underestimating Apparel and E-Commerce

Consumer Defensive: Not a Lot to Feast On

Energy: Supply Glut Continues, but Some Respite on Pricing

Financial Services: Accounting for Brexit and the Fiduciary Rule

Healthcare: Stock Selection Increasingly Important

Industrials: Valuations Stretched, but Opportunities Still Exist

Real Estate: 'Safety' Becomes More Expensive

Tech & Telecom: We See Opportunities in Apple and Microsoft

Utilities: Is a Sector-Shaking Pile-up Coming?

Second Quarter in U.S.-Stock Funds: The Winners and Losers

The First Half in International-Stock Funds

Second-Quarter in Bond Funds: Risk Pays Off

Benz: A 5-Step Midyear Portfolio Checkup