Our Outlook for the Stock Market

In an overall fairly valued market, it's time to be selective

Heather Brilliant, CFA 3 April, 2013 | 6:38PM
  • With its recent rally, the stock market is now trading just below fair value, with stocks under Morningstar coverage trading at 97% of fair value, using a market-capitalisation-weighted average. This is quite a bit higher than last quarter, when our coverage universe was trading at 92% of fair value.
  • We have seen correlations among asset classes start to come down (albeit from very high levels), which bolsters our view stated last quarter, that we think investors focusing on specific stock opportunities should do well given this backdrop.
  • Supporting our view that markets will continue to decouple, economic and market performance has meaningfully diverged during the first quarter. The US economy continues to show improvement, while Europe's weakness persists, and uncertainty in Asia has dragged market performance down in that region.

 

Global equity markets continued their march upward in the first quarter, making undervalued stocks all that much more challenging to find. Our overall coverage universe is trading at 97% of fair value, based on a market-cap-weighted average. Within that, our US coverage is the most expensive, trading at 99% of fair value, followed by Europe at 96% of fair value; Asia is the least expensive at 93% of fair value.

These recent discrepancies in valuation across regions are largely due to stock price changes in the regions as opposed to changes in our underlying valuations. In the first quarter to date, we have seen the S&P 500 rise more than 9%, far outpacing the roughly 3% improvement in Europe or 4% decline in Asia (excluding Japan).

Time to Be Selective

What does this mean for investors? We've received a lot of questions lately about the valuation of the overall market--understandably so, given the recent run. A fairly valued market is a challenge from an investing perspective because it doesn't send a clear signal either way. There are a couple of key takeaways for investors, but it boils down to one idea: Be selective with your investment decisions. Just because the overall market is fairly valued doesn't mean that every stock is fairly valued.

First, keep your favourite wide-moat businesses on your watch list, and buy them below fair value. Wide economic moats have the added advantage of compounding returns over time, so generally speaking, we'd rather buy a fairly valued wide-moat firm than a fairly valued business without a moat. Don't forget to be disciplined about your buy decisions, though; a margin of safety still gives you added advantage by further skewing the potential reward in your favour relative to the risk.

Second, focus on individual stocks and themes, rather than investments that expose you to the overall market. Index funds and exchange-traded funds can be great for adding market exposure at lower costs, but if we're right that correlations are declining, we think investors will face better risk/return opportunities buying strong businesses that are undervalued. We also think there are some interesting themes that investors with a long time horizon can take advantage of, such as an improving picture for natural gas in the United States.

You may be thinking: That's great, but there are hardly any attractively valued stocks right now. We agree, with only 24 US-listed 5-star stocks as of March 19. However, that has not always been the case. Below is a graph showing the median price/fair value ratio of the stocks under Morningstar coverage. Please note we are using a median here, although we discussed a market-cap-weighted average above, so the price/fair value ratios differ slightly. We have a greater history with the median data although we do like the granularity of information we can glean with the market-cap-weighted averages.

It's clear from the chart that we view stocks as slightly overvalued on a median basis at the moment, but you can also see how this has changed over time. Just a year ago, we thought stocks were about 10% undervalued, and at the depths of the financial crisis we had more than 800 5-star-rated stocks. The point is, we think it pays to be patient and wait for a margin of safety when investing in stocks.

Stocks vs. Bonds

Investors face a difficult dilemma at the moment, given the choices of stocks and bonds. As Dave Sekera notes in our quarterly outlook for bonds, we view US corporate bonds as fully valued at current spreads. With stocks and bonds fully valued, the decision of where to put one's money is not an easy one from a top-down perspective.

Although neither asset class looks particularly attractive based on valuations, we'd rather own stocks than bonds in this environment. The US economy is improving, and expectations for the depth of improvement remain relatively muted, giving the stock market a chance to surprise on the upside. However, any acceleration in economic growth could come with inflation, which tips us even further in the direction of favouring stocks. Combine that with the lower correlations we have seen year to date among markets around the world, and we think investors will be better served in 2013 to stick to specific stock ideas and themes. 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Heather Brilliant, CFA  Heather Brilliant, CFA, is the vice president of Global Equity and Credit Research at Morningstar.

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