Our View of the U.S. Market Entering 2006

Although slices of the U.S. market appeared overvalued at the start of 2006, some surprising pockets of opportunity remain. Many of the country's largest, best known firms are estimated by Morningstar analysts to be trading at significant discounts to their fair market values.

Haywood Kelly 30 January, 2006 | 9:15PM

IMA figures show that only 4.2% of the assets in unit trusts and OEICs sold to UK investors were in offerings specializing in North American securities at the close of 2005. However, the importance of the U.S. stock market in a global context is undeniable. The total capitalization of the U.S. market is roughly 45% to 50% of global market capitalization, and UK stocks tend to be highly correlated with their U.S. counterparts. With that in mind, we’ll take a closer look at where the U.S market stood at the beginning of 2006, and where it might be headed in the year to come.

As an astute investor, whenever you read the words "Economists predict that ..." you know to skip to the next article. Predicting anything as complex as the economy, whether one focuses on interest rates, the stock market, or next month's inflation figure, is an exercise in futility. And the more confidence an expert has in her macro prediction, the less credence you should put in it. Experts in any field tend to exhibit more confidence than the facts--or their own track records--justify.

So how can Morningstar have a view of the U.S. stock market? What we mean by "view" isn't a prediction of what the market will return in 2006. We don't know. Instead, we refer to our opinion on the valuation of individual stocks--as embedded in our fair value estimates. Our analysts estimate these fair values one stock at a time, but we can roll these fair values up to form a picture of the overall valuation of the U.S. market. Morningstar's U.S. team covers 1,700 stocks, so we think we have a pretty good idea of how the market, and various sectors of the market, are currently valued.

Where We Stand Today
We entered 2006 with 83 5-star stocks, which as a percentage of our coverage universe is 5%. As a refresher, 5-star stocks are those we consider attractive buying opportunities because they trade at a significant discount to our estimate of fair value--or our estimate of what a rational investor would pay for the company's future cash flows.*

In itself, having 5% of the universe rated 5 star is neither optimistic nor pessimistic. We can compare that figure with historical levels, though, to put it in perspective. Although that 5% is higher than at the beginning of 2005, when the percentage was just 2%, we've hovered right around 5% for much of the past year. This reflects the low volatility (and low returns) of the overall market. The S&P 500 finished 2005 up 4.8%, and didn't take too many detours to get there.

 Star Rating Distribution
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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.

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Haywood Kelly  Guest Author

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