Our outlook for the US market
The continuing rally in 2009 has left us searching lower (and higher) for buying opportunities
We thought the US market looked cheap back in March 2009, but it looked closer to fairly valued in June, and we think it has grown even more fairly valued today. In fact, our median price/fair value ratio for the market has risen above 1.0 (e.g., more stock prices have risen above our fair value estimates) for the first time since the middle of 2007.
The continuing rally in 2009 has left us searching lower (and higher) for buying opportunities. They've grown increasingly scarce, and increasingly concentrated among companies in our "wide moat" category.
That's the basic message from our bottom-up research on individual firms. We estimate fair values for these firms using discounted cash flow methods, and we regularly track those fair values along with the underlying stock prices.
Our Market Valuation Graph shows the median price to fair value ratio for our whole research coverage universe. That tool also breaks the data out for the companies in our economic moat and uncertainty categories.
It's been a pretty bleak environment for US stock investors since the
beginning of that market valuation graph in 2001, relative to historical
experience anyway. If you had put a dollar into the S&P 500 every
trading day over that period, those 2,077 dollars would be worth $1,968
today, or about 5% less than what you had invested, even after adjusting
for dividends.
But if you had invested those dollars in the S&P 500 only when our price/fair value ratio was below 1, (e.g., when the collective "call" from our bottom-up research on individual companies suggested the market was undervalued), those 915 dollars would be worth $927 today.
It's worth noting that we don't rate stocks "consider buy" until their prices fall below a margin of safety based on the risk of the firm. Adjusting for this, if you put $1 into the S&P 500 only when our price-fair value ratio was below 0.9, those 428 dollars would be worth $460 today, a gain of about 7%. And the dollars that you didn't put into the market when the price-fair value ratio was above 0.9 could have been getting a return elsewhere.
That's looking backward, of course, and we still believe it's a market of stocks, not a stock market. Digging into the overall totals, the table below reports the median price/fair value ratio for our equity research coverage universe at the end of the first quarter, the second quarter, and the current quarter coming to a close. We've seen a steady march upward in these ratios; in fact, the overall median price/fair value ratio has risen fully 35% since March 2009.
The increases run largest to smallest from our "no-moat" to "narrow moat" to "wide moat" categories. Put another way, the US market rally has been relatively strong among companies with relatively weak competitive positions, and we think stocks in general have grown increasingly less attractive, particularly weaker firms.
In fact, we think buying opportunities among firms with our "no moat" rating have grown close to nil. We have 5-star or "consider buy" ratings on only 1% of the 927 firms we've rated as "no moat" companies. We have double the rate of purchase recommendations among the 767 companies we've rated as having "narrow" economic moats, with 2% of those firms currently drawing our 5-star rating. That's not to say that we think there are zero opportunities in those categories, and we provide some insights on that score below.
But it's among the 174 companies we call "wide moat" firms where the buying opportunities appear concentrated. We have 5-star ratings on 26 (about 15%) of those companies as of Sept. 30. Even there, however, the frequency of buy recommendations has fallen considerably (roughly in half) since the second quarter. Looking at the industry mix of wide moat firms we're recommending, our health-care services team accounts for almost half of those 24 recommendations.
Consistent with its concentration of 5-star, wide-moat stocks, the health-care sector still has the lowest P/FV sector ratio. We still think there is a lot of value to be had in that area, but good individual buying ideas can be found in the relatively expensive sectors as well. Learn more about these opportunities and the trends, risks, and performance factors in each of these market sectors in the special reports below. Happy hunting!
We believe that the worst of the consumer credit cycle may be approaching, but we expect to see an increase in commercial credit losses. On the valuation front, after a quick banking sector rebound from March lows, a few regional bank names still stand out as values.
China's commodity purchases continued to provide a much-needed boost to weak global demand in the third quarter, but its appetite for commodities could lose some momentum in the fourth. In 2010, we expect stimulus spending on roads and infrastructure and a recovery in residential construction to drive growth in demand for construction materials, which will be somewhat offset by declines in nonresidential construction spending.
2008 and early 2009 was a traumatic period for a lot of insurance companies, but that dark time has given way to some recovery in the last six months. Different segments in the insurance sector have been drawn in sharp relief during the events of the past couple of years, and it is these differences that will determine the segments' paths in the future.
Looking forward, year-over-year comparisons get dramatically easier through the rest of calendar 2009 as we lap "deer in the headlights" consumer paralysis in the fourth quarter of 2008. Still, easy comps can only last so long, and eventually, we need the positive signs in other parts of the economy to generate increased wages. Given this environment, we think most investors should stick with solid companies trading at reasonable discounts instead of the riskier, less-certain investments.
Energy stock investors have looked past many of the present difficulties, with higher oil prices, improving sentiment about future natural gas prices, and healthier credit markets combining to drive the second and third quarter 2009 rally. We've picked five stocks from our 4- and 5-star list to keep on your radar.
While reform and its implications have been the main determinant of the direction of health-care stocks in 2009, another broad industry trend is emerging quietly. Mergers and acquisitions in the health-care sector have picked up. On the valuation front, medical device firms continue to lag the overall recovery pace, but we think they represent compelling investment opportunities today.
Our outlook for U.S. industrial activity has brightened for the rest of 2009 and into 2010, as several indicators that looked as if they might be bottoming earlier this year may have finally turned the corner in the just-ended three-month period.
We continue to believe well-positioned firms in this sector will emerge stronger while leaving behind weaker players. Some of the most poorly positioned firms have seen their shares skyrocket over the past three months, though, which we believe has created potholes for investors.
The results of the last few months bear the marks of three trends: inventory restocking, the release of Apple's iPhone 3GS, and the continuing popularity of netbooks. With respect to valuation: After a one-way rally in risky assets, we think it will be difficult for most technology stocks, especially the lower-quality names that have led this rally, to appreciate much further.
If the investment profiles of regulated and merchant utilities have always been distinct, we think the differences between them will only sharpen in the quarters ahead. The fortunes of both groups are likely to improve, but the former may be shackled by protracted demand weakness and guarded regulators, while merchant power producers, which also harbor uncertainty, hold greater upside potential, in our opinion.
