Stock Market Outlook: Minor Correction Not Enough to Make Stocks Cheap
We favor bottom-up stock analysis to find pockets of value amid a fairly valued market.
At Last, a Correction!
The long-awaited stock market correction finally came in August, with the S&P 500 declining 12.5% from its recent high to its recent low. It was the market's first correction since 2011, and the blame fell to long-simmering problems such as slowing growth in China and other emerging markets, the crash in commodity prices, and fears surrounding the Federal Reserve's first interest-rate hike. It seems unlikely that these worries will be going away any time soon, though the S&P had already gained back almost half of its losses by mid-September.
Investors may be tempted to call this correction a buying opportunity, especially after the past few years when it seemed like almost no stocks were on sale. Unfortunately, the S&P 500 was richly valued before this downturn, so it will take a lot more than a small correction to really get excited about the market as a whole. We continue to favor bottom-up stock analysis to find pockets of value, rather than relying on a rising tide to lift all boats.
Commodities Bring More Pain
As of mid-September, the basic materials and energy sectors were down 15% and 30% year to date, respectively. Declines accelerated over the past quarter as the bursting of China's stock market bubble raised new concerns about that country's economic health. In recent years, China has accounted for as much as half of global demand for key industrial commodities such as iron ore, copper, and coal.
Explaining the steep drop in commodity prices is fairly simple: There's too much supply, not enough demand. Unfortunately, a solution to this problem is elusive. Aside from its near-term economic slump, China desperately needs to transition its economy away from debt-fueled infrastructure investment toward a more sustainable model focused around consumer spending. It's a transition that every developed economy went through at one time or another, and with China already overwhelmed by excess capacity, demand for basic materials probably won't rebound to former levels any time soon. Compounding this problem is the surge in long-lived, low-cost production capacity by major industrial commodity miners.
The outlook for energy isn't much better in the short term, though at least there are mechanisms to balance supply and demand within the next few years. We recently lowered our long-run oil price forecast to $70 per barrel for Brent and $64 per barrel for West Texas Intermediate--both down $5 from our previous estimates. Thanks to improving efficiency, oil production from U.S. shale plays has been remarkably robust despite sharply lower rig counts.
The nuclear deal with Iran, falling oilfield-services pricing, and depreciation in the currencies of oil-exporting countries contribute to our more bearish take on oil. Oil prices are likely to remain below our long-term estimate until at least 2017 because of supply and inventory overhangs. However, we don't think current prices are sufficient to encourage investment over the long run, and natural decline curves should eventually bring the market into balance.
Financial-Services Sector Looks Undervalued
The market correction was enough to bring the median stock in every sector below Morningstar's fair value estimate, but in most cases these discounts are modest, ranging from 2% (communication services) to 9% (basic materials). The primary exception is financial services, which as of this writing in mid-September was trading 15% below our fair value estimate. Banks and other financial-services providers stand to benefit from higher interest rates, and investors had become hopeful that the Federal Reserve would raise short-term rates at its September meeting. When the Fed held rates near zero instead, financial stocks retreated, but we still think higher rates are inevitable over the long run.
Elsewhere, our recommendations are driven by stock- and industry-specific considerations. We see internal turnarounds gaining momentum at Procter & Gamble (PG) and General Electric (GE). Railroads are out of favor because of precipitous declines in coal volumes, but we like the long-run cost advantages of Union Pacific (UNP), CSX (CSX), and Norfolk Southern (NSC), among others. Media investors are concerned about "cord cutting," but we suspect this risk is overblown, and we see value in Disney (DIS), Time Warner (TWX), and Twenty-First Century Fox (FOX). A handful of biotech stocks also look cheap based on their strong pipeline prospects, such as Amgen (AMGN) and Biogen (BIIB). For more of our current favorites, see this week's sector reports on Morningstar.com.
The median stock in Morningstar's coverage carried a price/fair value ratio of 0.94 as of mid-September. That's pretty good relative to the past few years, when the median stock has frequently traded at a premium to fair value. However, it's unimpressive when you take a longer-term historical perspective. During the 2011 pullback, the median stock bottomed at a price/fair value ratio of just 0.77. At the lows of the 2008-09 crash, the median price/fair value ratio fell to 0.55. In other words, today's valuation levels certainly don't represent a historic buying opportunity.
The S&P 500 sits at 1,958 as of this writing. This implies a price/earnings ratio of 18.5 using trailing 12-month operating earnings, 24.8 using a 10-year average of inflation-adjusted earnings (the Shiller P/E), or 17.1 using trailing peak operating earnings. Those measures have been lower 59%, 53%, and 61% of the time since 1989, respectively.
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Matthew Coffina has a position in the following securities mentioned above: UNP, TWX. Find out about Morningstar’s editorial policies.