How to invest after the first-half rally

The first half of 2009 was another wild period for the stock market, but most investors would probably agree that things look better now than they did a few months ago. The economy has shown signs of stabilising, and nobody is talking any more about the collapse and/or nationalisation of the banking system, as some people were earlier in the year. The FTSE 100 Index is up by almost 20% from its March 9 low, and other indices are up by similar amounts.

Despite all this, few people are unreservedly bullish. The economic signals are still mixed, and even the best-case scenarios have the recession continuing until later this year. Sceptics have been saying for a while that stock prices have moved ahead of their fundamentals, and the major indices have retreated from their highs over the past couple of weeks. The possibility of a further pullback is real, especially if more bad economic news comes out.

What's an investor to do? Even the bulls agree that a 20% gain in three months is unusual and unsustainable, and quite a few smart investors, including PIMCO's Bill Gross, think that future economic growth and investment returns will be lower than they were before the market crash. Morningstar analyst Chris Davis recently provided some good advice for investing in this "new normal," and among that advice was "don't give up on stocks." Even if you agree that future stock returns are likely to be muted, stocks should still outperform most other investments over time, and there are usually some good values out there if you know where to look.

With all that in mind, here are some tips for investing in stocks at this uncertain time, especially if you've been on the sidelines but are now thinking about putting some money to work in the market.

Are there any bargains left?
The big question for investors is whether the market has gone too far in this latest upswing or whether there are still bargains to be had. It's impossible to know for sure, but one way to get some idea is to look at the fair value estimates that analysts assign to stocks and compare them with current stock prices. If a stock's price/fair value ratio is below 1.0, analysts think that it's being undervalued by the market. By aggregating price/fair value ratios for many stocks, it's possible to get an idea of whether the market as a whole, or some part of it, looks overvalued or undervalued.

Morningstar's Bill Bergman recently surveyed our own stock coverage universe in these terms. He found that the market doesn't look nearly as cheap now as it did in early March, before the rally, though it's not too expensive either. You can see for yourself by looking at our Market Valuation Graph, which plots the median price/fair value ratio of our coverage universe over time. Back in November 2008, that ratio got as low as 0.55, meaning that the median stock was trading at barely half of its estimated fair value, and in early March it was still close to 0.60. Now, however, it's above 0.90, suggesting that the market as a whole is close to being fairly valued.

Yet, as Bergman also points out, some parts of the market are still quite a bit cheaper than others. At a sector level, the median health-care stock had a price/fair value ratio of 0.73 as of June 26, by far the lowest of our 10 industry groups. That's not too surprising, given that health care was among the worst-performing sectors in the recent rally, largely because of uncertainty about the effects of health-care reform in the US. While the risks can't be ignored, bargain-hunters have plenty of opportunities here.

Another group that's relatively cheap is wide-moat stocks, or those that our analysts believe have significant competitive advantages. Wide-moat stocks had a median price/fair value ratio of 0.79 as of June 26, compared with 0.87 for narrow-moat stocks and 1.01 for no-moat stocks. This pattern is not very surprising, either; the recent rally was driven mainly by risky stocks, while predictable, stable names--a description that fits most wide-moat stocks--gained significantly less. (On the flip side, those wide-moat names held up better than their moat-challenged counterparts during the downturn.)

Be wary of what's hot
The flip side of hunting for bargains is being wary of whichever investments have been hot lately, because often those are among the worst investments to get into at a given time. The classic example is technology stocks in 1999 and early 2000; lots of people piled into these stocks near the market top, attracted by their eye-poppingly high returns, then got burned when the stocks plunged in price. More recently, in the second half of 2007, large-growth stocks such as Apple and Google put up huge gains on Wall Street, but those same stocks fell hard in the first months of 2008 after it became clear that we were in a recession.

For the same reasons, it's a good idea to be sceptical of the hottest investments in the recent rally. That's especially true because, as noted above, those hot investments have mostly been risky, highly cyclical investments, including some of the areas that got beaten up the worst in the second half of 2008. The best-performing stock-fund categories over the past three months have been the various emerging-markets categories and global real estate, while among fixed-income funds, high-yield and bank-loan funds have had the biggest gains. These economically sensitive groups are among the riskiest categories out there, with some of the biggest losses in 2008. Investors bid them up in the first half in anticipation of an economic recovery, but they could struggle if the recovery isn't as strong as expected.

Within US equity, bank stocks have posted big gains since early March as people realised that a complete collapse of the banking system wasn't in the cards. Those stocks were quite cheap back in March, according to our analysts' estimates, but they're now close to fairly valued, with very high levels of uncertainty. Energy and basic-materials stocks were also among the biggest gainers from March to June, but they're now about fairly valued.

Admittedly, these sectors aren't nearly as scary as tech or Internet stocks in early 2000, which were wildly overvalued by virtually any measure. But they're unlikely to replicate their great recent performance going forward, and somebody who buys these stocks expecting a continuation of that performance may be disappointed.

Don't try to time the market
Of course, in the short term, it's entirely possible that banks and materials stocks could stage another big rally, and that health care could continue to languish. If there are any lessons to be learned from the crazy market gyrations of the past couple of years, it's that nobody knows for sure where the market is going, and that even when "experts" try to predict it, they're often wrong.

That's why, if you're planning to invest after sitting on the sidelines, it's a good idea to do so in a prudent and systematic way. Once you've decided which investments you want to be in, pound-cost averaging is one good way to control your risk and take the emotion out of the process. Pound-cost averaging is just another name for investing the same amount at regular intervals, but it tends to result in smoother and better returns than strategies that involve trying to time the market.

It's also important to be sure that any new investments you make don't skew your asset allocation too far away from where you want it to be, especially if you're adding more stocks after being in bonds and/or cash. This column by Christine Benz gives some essential tips for reviewing your portfolio.

A version of this article previously featured on Morningstar.com.