Stock Market Outlook: Volatility Creates Pockets of Opportunity
Adventurous investors may find opportunities in out-of-favor energy and basic materials stocks, but the valuation of the overall market still leaves little margin for error.
Oil Price Crash Brings Pain, and Opportunity, for Energy Investors
As of this writing in mid-December, the S&P 500 is trading near all-time highs, but that figure understates the extent of recent volatility. Energy stocks are down by nearly 25% over the past three months, and there are now 37 energy companies carrying Morningstar's 5-star rating. That's compared with just 10 5-star stocks across Morningstar's entire coverage universe when we published our last quarterly outlook. Our broader coverage universe now includes 64 5-stars, with the median stock trading 1% below fair value, by our estimation.
Our contrarian take on energy has a simple explanation: Investors are terrified of the collapse in crude oil prices since June, but our analysts think this is a temporary setback. While we've lowered our near-term oil price expectations in line with the market, our long-run oil price forecast remains $100/barrel for Brent and $90/barrel for West Texas Intermediate (WTI). And the "long run"--all the years beyond the next three--is the primary determinant of our fair value estimates.
To be sure, the speed and extent of the recent plunge in oil prices took us by surprise after more than three years of relatively stable prices in the $100/barrel range. It's all about Economics 101: supply and demand. North America's energy boom has increased supply, augmented by surprisingly strong production out of the Middle East and North Africa despite political turmoil in that region. At the same time, the demand outlook has weakened, with many economies around the world slowing (China) or in borderline recessions (Japan, Brazil, much of Europe).
Morningstar's long-run oil price assumptions are based on the "marginal cost of production"--we believe a Brent price of $100/barrel is necessary to stimulate investment in the highest-cost resources such as ultra-deep-water and oil sands mining. However, investors should keep in mind that marginal cost is a moving target. First, growth in lower-cost sources of supply--especially if combined with slowing demand--can push high-cost resources off the supply curve altogether. If we can meet our oil needs without the highest-cost resources, then they lose their relevance to setting oil prices. Second, oilfield-services pricing is a major determinant of marginal costs. As oil and gas companies cut back on drilling, there may be an excess supply of rigs, equipment, labor, and so on, resulting in lower services pricing and lower marginal costs. At the very least, investors should understand that our $100/barrel forecast involves a high degree of uncertainty, making a margin of safety indispensable for new purchases.
On the plus side, such margins of safety are now widely available in energy, even though we've been ratcheting down our valuations to incorporate lower near-term oil prices. As of mid-December, the median energy stock in our coverage universe was trading 27% below our fair value estimate, making energy the cheapest sector on that measure by far. There are two key factors that should support oil prices over the longer run: Natural decline curves, which reduce global oil supply by 4%-5% per year absent new investment, and the fact that incremental oil and gas resources are in relatively remote, difficult-to-access locations.
Risk and Reward Go Hand in Hand
A theme from the energy sector pervades the rest of the market as well: Undervalued stocks generally come with elevated risk, especially from economic sensitivity and currency exposure. After energy, the next most undervalued sector we cover is basic materials, where the median stock is trading 11% below our fair value estimate as of mid-December.
The basic materials sector has been down over the past three months because of concerns about slowing economic growth in China. It's hard to overstate the importance of China to global commodities demand. For example, China accounts for about half of global steel demand and two thirds of the seaborne iron ore market. We think China's steel consumption has peaked and is set for a steady decline over the next several years as the Chinese economy rebalances toward consumption instead of investment spending. Iron ore prices fell by half thus far in 2014, and we think other commodities such as copper won't be far behind. Given this macroeconomic uncertainty, investors should tread carefully--we would focus on low-cost miners with sustainable competitive advantages.
Despite recent underperformance relative to the overall market, other cyclical sectors such as technology and industrials continue to trade at premiums to our fair value estimates, reflecting high starting valuations. Defensive sectors--such as consumer staples, health care, utilities, and real estate--are also trading above our fair value estimates, having outperformed over the past quarter. Defensive investors owe much of the recent performance to a persistent decline in long-term interest rates, with the 10-year Treasury yield falling to just above 2%, compared to 3% at the start of the year. The bond market seems to be a lot more pessimistic about the U.S. economic outlook than the Federal Reserve, which continues to hint at short-term rate increases starting in 2015. Pockets of opportunity can still be found in these sectors, but investors need to be as discerning as ever.
Market Still Seems Fully Valued
Turning to the valuation of the overall market, the median stock in Morningstar's coverage universe was trading just below our fair value estimate as of mid-December, with undervalued energy and certain other cyclical stocks offsetting modest overvaluation in more defensive sectors.
With the S&P 500 at 1,973 as of this writing, the Shiller price/earnings ratio--which uses a 10-year average of inflation-adjusted earnings in the denominator--is roughly 25.7. That's down from 26.5 the last time we provided our quarterly outlook, but is still higher than 63% of the monthly readings since 1989. Shiller P/E ratios above 25 have historically been associated with poor subsequent five-year total returns and an elevated risk of a material drawdown, having primarily been witnessed in the lead-up to market crashes (1929, 2000-02, and 2008-09). On the other hand, interest rates remain far below historical norms--if sustained, low interest rates could justify substantially higher P/E ratios than we're used to.
There's no shortage of investors who object to the use of the Shiller P/E as a measure of market valuation. We'll readily admit that this metric is far from perfect--it is slow to incorporate new information; it may penalize earnings for too long following a severe recession; its central tendency can shift dramatically over decades-long stretches; and even under the best of circumstances, variability in the Shiller P/E can predict no more than half of future total returns. But that doesn't mean the measure has no value--we just have to be aware of its limitations.
Another measure of market valuation compares the current level of the S&P 500 with trailing peak operating earnings. This metric stands around 17.0--equal to the trailing-12-month operating P/E since operating earnings are at an all-time high. Since this measure only looks at trailing peak earnings, it isn't skewed by unusually low earnings during past recessions, especially in 2008-09. Even so, at 17.0, this measure has been lower 62% of the time since 1989, conveying a similar message as the Shiller P/E.
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