Stock Market Outlook: A Little Too Buoyant?

• The Morningstar Global Markets Index has returned 7.6% year to date and 12.1% over the past year.
• The market-cap-weighted price/fair value estimate ratio for our equity analysts' coverage universe is 1.03.
• Financial services and healthcare are the most undervalued sectors, both with price/fair value estimate ratios of 0.94. Basic materials and energy are the most overvalued sectors, with price/fair value estimate ratios of 1.28 and 1.22, respectively.

Given that corporate earnings have been weak this year, it is somewhat surprising that equity markets have remained so buoyant. Stock prices have recovered from early 2016 fears regarding China's economy and low oil prices as well as June's reaction to the United Kingdom's vote to leave the European Union. Morningstar's director of economic analysis, Bob Johnson, has started to forecast a slowing of the U.S. economy as a result of such factors as weaker auto demand and the end of the Affordable Care Act boost in healthcare spending. Overall, our analysts find our coverage universe to be slightly overvalued.

The financial-services sector became less undervalued during the quarter, in part because our analysts lowered their fair value estimates for several U.K. banks such as  Barclays (BCS),  Royal Bank of Scotland (RBS),  Lloyds (LYG), and  Banco Santander (SAN). After Brexit in late June, we lowered our assumptions for loan growth and fees while increasing our funding cost assumptions. Although the trade implications of the U.K. leaving the EU will take time to show, companies such as Lloyds have already begun to act by closing branches, laying off employees, and selling property. Our top picks in the financial-services sector are  Affiliated Managers Group (AMG),  Commerzbank (CBK), and  Aegon (AEG).

Three major trends are defining the healthcare sector in 2016. First, the media have given high drug prices increased attention, and both presidential candidates promise to lower drug costs for Americans. Although our healthcare team forecasts that older generic drugs will indeed face increased pricing pressure going forward, innovative drugs should maintain their pricing power for the next several years.

Second, drug companies have halved the time it takes to bring a drug to market compared with a decade ago, thanks to scientific advancements and more-accommodative regulations, particularly in oncology and immunology. These successes augur well for attractive and sustainable economic profits.

Third, low interest rates and a search for growth have encouraged numerous acquisition and merger attempts. Given the environment, investors should be concerned about value destruction through M&A activity. For example, our analysts assessed  Pfizer's (PFE) acquisition of Medivation as overvalued (mitigated by the size of the deal relative to Pfizer's enterprise value), and regulators have stopped acquisitions in the drug and managed care industries. Our top picks in healthcare are  Allergan where investor concerns about the broad specialty pharma industry are overshadowing the company's innovative pipeline;  Roche (RHHBY), whose drug and diagnostics portfolio is being undervalued by the market; and Elekta (EKTA B), which despite company-specific concerns, is still well-positioned in the strong-growth radiotherapy market.

While our energy sector analysts expect oil prices to recover through 2018, they are bearish on oil long term. They expect U.S. shale oil production to start growing again in 2017 despite still-below-peak rig counts thanks to efficiency gains, drilled-but-uncompleted wells being brought on line, and falling decline rates. Our team's long-term oil price assumption is $55 per barrel for West Texas Intermediate, based on the argument that U.S. shale can supply much more crude oil than the world will actually need.

Our basic materials analysts find much of the sector overvalued, given below-consensus long-term expectations for aluminum, copper, iron ore, and steel prices. Industrial metal and steel prices rallied strongly this year as an increase in Chinese fixed-asset investment boosted demand. However, our analysts argue that the credit growth fueling the fixed asset investment is outpacing actual economic growth, and the presumed overinvestment in metals-intensive projects will ultimately lead to disappointing Chinese demand. To illustrate, we expect Chinese steel demand to fall to 653 million metric tons in 2020 compared with consensus expectations for 710 million metric tons of demand in 2020 and the peak of 765 million metric tons reached in 2013.

More Quarter-End Insights

Credit Market Insights: Leaving Brexit Behind

Basic Materials: China-Dependent Producers Largely Overvalued

Consumer Cyclical: Poised to Perform in the Second Half

Consumer Defensive: A Handful of Values in an Overheated Sector

Energy: Rally in the Works, but It Won't Last Long

Financial Services: Berkshire Is Bigger Than Buffett

Healthcare: We See Value in the Drug and Biotech Industries

Industrials: Weak Commodity Prices Weigh

Real Estate: Expect Some Choppy Waters Ahead

Tech & Telecom: Opportunities in Smartphones and IT Services

Utilities: How Long Can the Yield Paradox Survive?