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Stock Strategist

Stock Market Outlook: Stocks Start to Look More Attractive

Some fears are overblown, leading to attractive valuations in financial services and consumer cyclical.

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  • We view the overall market as slightly undervalued, based on our fair value estimates for approximately 1,500 global companies. 
  • The financial services, consumer cyclical, and healthcare sectors are the most undervalued, while the basic materials sector is our only overvalued sector.
  • Oil price concerns are hurting the financial services sector, while divergent paths for China's future fixed asset investment growth and consumption inform our thinking in the basic materials and consumer cyclical sectors.

 

Although the S&P 500 had fallen some 10% from the start of 2016, a strong bounce from mid-February puts us basically back to where we started the year. As of mid-March, the market-cap-weighted-average price/fair value ratio of our coverage universe is 0.92, down from 0.96 as of Dec. 15, 2015.

The financial services sector is by far the most undervalued based on our estimates of companies' intrinsic values, with a market-cap-weighted price/fair value ratio of 0.78. While investors are right to be somewhat concerned about energy-related credit losses, currently low interest rates, and possible interbank contagion, the magnitude of the coming losses priced into many bank stocks is overdone, and we find many to be sporting attractive valuations today. We believe most bank's exposure to the energy sector is ultimately manageable. And we believe fears regarding counterparty risk and notional derivative exposures are also overblown. Net exposures to individual asset classes, events, or counterparties are relatively manageable--especially in the case of interest rates, which make up a bulk of reported notional exposures.

That's not to say that it won't be a painful year for bank earnings. Net interest margins will likely remain depressed. Credit quality will likely deteriorate. And poor stock market returns would be bad news for capital markets and wealth management businesses. But to us, it seems like for many banks investors have priced in this pain, and much more. For example,  Citigroup (C) has been hit hard by fears over its emerging-markets exposures, but we think the long-term outlook for the bank is actually brightening. The company could take losses of 36% on its entire emerging-markets exposure (which would be at the high end of historical emerging-markets crisis ranges for loss rates) and maintain its current 12% Common Equity Tier 1 ratio.

The basic materials sector is currently the most overvalued, according to our estimates of companies' intrinsic values, with a market-cap-weighted price/fair value ratio of 1.13. Although the sector has already seemingly suffered more than its fair share of volatility and concerns about a slowdown in Chinese fixed-asset investment, we still think that there is more downside for all-important valuation drivers such as iron ore, metallurgical coal, and copper prices. Our bearishness rests on the assumption that Chinese steel demand will fall to 648 million metric tons by 2025, down from a peak of 765 million in 2013, because of slowing urbanization and absorption of excess real estate supply. In addition, rising scrap supply availability decreases the demand for key steel inputs, iron ore, and met coal. We also expect Chinese copper demand to disappoint, with 2015 levels representing a medium-term peak as demand from the construction sector weakens and demand from the power sector shifts toward aluminum. All told, we find miners such as  Teck Resources (TCK),  Anglo American (NGLOY),  Southern Copper (SCCO), and  Vale (VALE) to be quite overvalued, with these specific companies all sporting our 1-star rating currently.

In contrast, we think China-related fears are actually overblown in the consumer cyclical sector. Here, we have a market-cap-weighted price/fair value ratio of 0.89, making it the second-most attractively valued sector (after financial services). While we're bearish on China's fixed-asset investment and overall GDP growth rate, domestic consumption could still post high-single-digit growth over the next five years. In line with this, we're positive on China passenger vehicle sales, and we forecast annual light vehicle registrations climbing to 23.7 million in 2020 from an estimated 20.5 million in 2015.  Fiat Chrysler  (FCAU) is one of the most attractively priced stocks in the consumer sector. Although the company was late to enter China, Jeep's re-entry into China should provide 5-star-rated Fiat with growth potential.  Wynn Resorts (WYNN), currently rated 4 stars, is well- positioned for the long-term growth we expect to see in the Macau region.

More Quarter-End Insights

Credit: Corporate Bond Markets Recuperate

Basic Materials: The Recent Commodity Rally Shouldn't Give Investors Hope

Consumer Cyclical: China Growth Concerns Present Buying Opportunities

Consumer Defensive: Lofty Valuations Persist, but a Handful of Bargains Remain

Energy: Don't Expect a Quick Recovery for Crude Prices

Financial Services: Global Bank Rout Is Overdone

Healthcare: Drug Reform Worries Are Overblown

Industrials: An Uneven Start to 2016, but Compelling Values Remain

Real Estate: Companies With Enduring Demand Will Persevere

Tech, Telecom & Media: Long-Term Opportunities Amid Software's Storm

Utilities: Dividends Still Attractive, but Headwinds Remain

Elizabeth Collins has a position in the following securities mentioned above: VALE. Find out about Morningstar’s editorial policies.