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The U.S. Market: Under-, Over-, or Fairly Valued?

GLOBAL EQUITIES WEEK: We examine the valuations on two U.S. broad market ETFs for insight.

Jason Stipp 5 December, 2011 | 10:59AM

Read more on global equity investing here.

The S&P 500 has taken a beating over the past 10 years, up only 2.5% on an annualised basis (as of Nov. 28). That anaemic return came with incredible ups and downs, while safer bonds offered a 5.7% return with less volatility over the same period.

But at this point, the outlook for U.S. stocks has improved. Now, in late November, the S&P 500 is trading at the same level it hit in late 1998. Yet the underlying companies have grown considerably over the trailing decade. Profits in 2011 are expected to reach levels not achieved since before the crisis. And the dividend yield on the S&P 500 is higher than the yield on 10-year U.S. Treasury bonds, a rare occurrence that bodes well for stocks.

Why have U.S. stocks struggled lately? U.S. economic growth hit a soft patch in the first half of 2011, stirring fears that the economy might dip back into a recession. However, from a fundamental standpoint, U.S. firms are in a better position to handle an economic slowdown than they were three years ago. Since that time, corporations have reduced debt and raised cash.

But just how attractive does the market look at current levels? One way to get a handle on market valuation is by digging into Morningstar's ETF research and data. Most equity ETFs track indices that are designed to capture the performance of certain regional markets, stock sectors, or other attributes. ETF portfolios are also transparent and reported daily by the ETF providers, so investors have much more certainty about ETFs' current holdings. Given this timely portfolio data, Morningstar analysts are able to calculate a fair value estimate for an ETF's portfolio by rolling up Morningstar's individual fair value estimates for the underlying stocks. (Our stock analysts have such estimates for about 1,350 companies.)

We took a look at the valuation data on a couple of broad-market U.S.-focused ETFs to glean some insight into overall market valuations. Excerpts based on Morningstar ETF analyst Mike Rawson's research reports on these funds are below.

Dow Jones Industrial Average: High-Quality on Sale
As of Nov. 29, the SPDR Dow Jones Industrial Average ETF (DIA) had a fair value estimate of $136 per share versus a current trading price of $116, making the market proxy about 15% undervalued. Morningstar analysts cover all 30 stocks in the DJIA, meaning we have a fair value estimate on each of the names.

The Dow contains only the largest mega-cap stocks, and over 71% of the asset-weighting of the index is in stocks with a wide economic moat. (The moat rating--wide, narrow, and none--is how Morningstar analysts measure of the quality and defensibility of a firm's competitive economic advantage.) This indicates that DIA has a very high-quality portfolio of companies.

A quick look at the index constituents reveals that Morningstar has the highest rating (5-stars) on 3M, Exxon, Cisco Systems, GE, and a few others. A 5-star rating means that the stock trades at a discount to Morningstar's fair value estimate for the shares. The size of the discount required to attain 5 stars depends on our estimate of certainty about that fair value estimate--more uncertainty means a greater required discount, or margin of safety. Meanwhile our analysts consider Coca-Cola, Verizon, and Wal-Mart more fairly valued (3 stars). Currently, there are no 1- or 2-star (overvalued) stocks in the index.

Before extrapolating too much about the overall U.S. market's valuation from this ETF, however, it's important to note that the index itself has several quirks. First, instead of market-capitalisation weighting, the index uses share-price weighting. So, although Microsoft has about the same market cap as IBM, its low share price means that Microsoft makes up less than 2% of the index, while IBM, with its high share price, makes up over 10%. Meanwhile, Apple, currently the second-largest U.S. company by market cap, is not included. The index also excludes transportation and utility stocks and has an underweighting in financials but an overweighting in industrials relative to the S&P 500. However, despite these idiosyncrasies, the index has had a 0.97 correlation to the S&P 500 over the past 10 years and similar volatility.

Also, as mentioned before, small- and mid-sized companies are not represented here, so investors will have to look elsewhere for insight on valuations for those areas of the U.S. market. On that note, a quick check of the data on Vanguard Mid-Cap ETF (VO) suggests that U.S. smaller-cap stocks are not as cheap as their larger-cap counterparts. Based on Morningstar's fair value estimates, the Vanguard ETF is currently trading at a more modest 8% discount. (By assets, Morningstar has fair value estimates for approximately 80% of VO's portfolio.)

S&P 500 Stocks Trading at a Discount
Morningstar stock analysts have assigned fair value estimates to nearly every stock in the S&P 500 (by assets, we cover over 98% of the index) and held by the SPDR S&P 500 ETF (SPY). As of Nov 29, the stocks in the S&P trade at a 19% discount to Morningstar's fair value estimates.

Unlike the Dow Jones Industrial Average ETF, the SPDR S&P is market-cap weighted, which means multinational industry leaders such as ExxonMobil, Apple, and Microsoft have a lot of influence here. All three names also happen to be undervalued according to Morningstar's fair value estimates, with Exxon trading in 5-star, and Apple and Microsoft in 4-star territory. Despite the market-cap weighting, however, the top 10 holdings still account for less than 20% of assets, and no sector is weighted more than 20%.

A few things to keep in mind: Although the S&P is considered a proxy for the U.S. market, the index (and this ETF) contains large stakes in multinational firms and also has substantial indirect international exposure, with around 45% of the underlying companies' asset-weighted revenues coming from outside the U.S. Also, like the Dow Jones, the S&P has a large-cap tilt. However, despite lacking any exposure to small-cap or many mid-cap stocks, the index holds nearly 80% of the U.S. market's total value.

As both ETF valuation levels indicate, the recent market soft spot may be presenting an opportunity for investors to gain exposure to the U.S. market at reasonably compelling valuations--especially high-quality, blue-chip names. And those who cashed out during the financial crisis and were disappointed that they did not reinvest fast enough as the U.S. market rebounded might want to use this as a buying opportunity.

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

Jason Stipp  is Editor of Morningstar.com, the sister site of Morningstar.co.uk.

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