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Quarter-End Insights

Stock Market Outlook: Late-Cycle Behavior?

We're unenthusiastic about the valuation of the broader market, but opportunities can be found in a few out-of-favor sectors.

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  • The S&P 500 has made up most of the ground it lost in the August correction, but it once again looks fully valued. Investors should be prepared for modest returns over the next five years.
  • The market is increasingly driven by a handful of high-flying growth stocks such as (AMZN) and  Netflix (NFLX), leaving more opportunities in out-of-favor cyclicals and value stocks. We believe investors are too pessimistic about certain apparel, energy, and industrial companies, among others.
  • Depending on the metric used, the S&P has been cheaper on a normalized price/earnings basis two thirds to three fourths of the time over the past 25 years.

Late-Cycle Behavior?
While the S&P 500 is on track to end 2015 almost exactly where it started, earnings have deteriorated, pushing up valuation multiples. Earnings per share for the index are on track to decline at least 5% this year because of the strong U.S. dollar, weak commodity prices, slowing emerging-markets growth, and recession-like conditions in several industrial areas of the economy.

Market-timing has never been our game, but we can't help but notice signs that this bull market may be getting long in the tooth: the Federal Reserve's first interest-rate hike in a decade, a lack of market breadth, investors' willingness to pay almost any price for fast-growing but unprofitable "story stocks," signs of trouble in the junk-bond market, and records or near-records in share repurchase activity and mergers and acquisitions. Even if current profit margins and price/earnings ratios are sustainable, it seems unlikely that dividends and earnings growth can support total returns above 6%-8% per year over the long run. Investors should set their expectations accordingly.

Where Our Analysts Are Finding Value
The valuation of the overall market may not leave much margin for error, but diverging returns between industries have created a few areas of opportunity.

For example, although the consumer cyclical sector has posted the best year-to-date total returns, apparel firms and lower-ticket discretionary retailers have fallen out of favor. Some of the issues facing these firms are likely to prove temporary, including unseasonably warm weather, excess inventory, and a lack of new fashion trends. Other challenges are more secular in nature, such as rising labor costs and consumers' shift to online shopping. Our analysts see value in firms such as  VF Corp. (VFC),  Nordstrom (JWN), and  Gap (GPS). In the consumer defensive arena, we believe  Wal-Mart's (WMT) valuation already incorporates the growth and margin pressures confronting the world's largest retailer.

Falling commodity prices continue to buffet the energy and basic materials sectors. While both will face serious financial challenges in the near term, we're more optimistic about an intermediate-term turnaround in the former than the latter. Energy markets are significantly oversupplied--a situation made worse by OPEC's refusal to scale back production, improving drilling efficiency in U.S. shale plays, and storage facilities that are being filled to capacity. However, current oil and gas prices can't support the investment needed to meet long-term energy demand, and sooner or later natural decline curves will catch up to producers that are sharply cutting back on drilling activity. Our analysts favor energy firms with low costs and relatively strong balance sheets, including  ExxonMobil (XOM),  Continental Resources (CLR), and  Cabot Oil & Gas (COG).

It's a different story in the basic materials sector: We see China's move away from infrastructure investment as a permanent change, and new low-cost mining capacity is coming on line that could produce at peak levels for decades. We would avoid most industrial commodity miners, but are relatively more bullish on commodities linked to Chinese consumer spending, such as gold and fertilizer.

Low energy prices, the strong U.S. dollar (which hurts export demand), and global macroeconomic worries have also weighed on the industrials sector. Our analysts' picks include conglomerate  Emerson Electric (EMR), mining equipment manufacturer  Joy Global (JOY), and a number of railroads, such as  Canadian Pacific (CP),  Kansas City Southern (KSU), and  CSX (CSX). The auto industry has been a rare bright spot, and we find  General Motors (GM) and  Ford (F) to be undervalued.

Elsewhere, our analysts are finding discounted valuations for industry- and company-specific reasons in media, healthcare REITs, biotech, and Canadian banks.

Market Valuation
As of mid-December, the median stock covered by Morningstar trades with a price/fair value ratio of 0.95, roughly unchanged since last quarter. The S&P 500 stands at 2,073, implying a price/earnings ratio of 19.5 using trailing 12-month operating earnings, 26.2 using a 10-year average of inflation-adjusted earnings (the Shiller P/E), or 18.1 using trailing peak operating earnings. Those measures have been lower 67%, 67%, and 74% of the time since 1989, respectively. Valuation multiples have deteriorated since last quarter due to the combination of rising stock prices and falling earnings.

More Quarter-End Insights

Economic Outlook: Escape Velocity Not in the Cards for U.S. Growth

Credit Markets: Volatility and Spreads to Remain Elevated

Basic Materials: Fates Tied to Faltering China

Consumer Cyclical: Consumer Volatility Creates Investment Opportunities

Consumer Defensive: Bargains Harder to Come By

Energy: Pain Persists as OPEC Refuses to Play White Knight

Financial Services and Real Estate: Fiduciary Standard Rule Could Have Drastic Impact

Healthcare: Even After Uptick, Some Great Values Remain

Industrials: Unsettled Global Economy Serves Up Individual Stock Bargains

Tech & Telecom: Cord-Cutting and Programmatic Advertising Trends Continue

Utilities: Don't Fear the Fed--Yield and Growth Still Look Good After 2015 Slump

Matthew Coffina has a position in the following securities mentioned above: XOM, WMT. Find out about Morningstar’s editorial policies.