How to Invest after the First-Half Rally

Are There Any Bargains Left?
The big question for investors is whether the market has gone too far in this latest upswing or whether there are still bargains to be had. It's impossible to know for sure, but one way to get some idea is to look at the fair value estimates that Morningstar stock analysts assign to more than 2,000 stocks, and compare them with current stock prices. If a stock's price/fair value ratio is below 1.0, our analysts think that it's being undervalued by the market. By aggregating price/fair value ratios for many stocks, it's possible to get an idea of whether the market as a whole, or some part of it, looks overvalued or undervalued.

Morningstar's Bill Bergman recently surveyed our coverage universe in these terms. He found that the market doesn't look nearly as cheap now as it did in early March, before the rally, though it's not too expensive either. You can see for yourself by looking at our Market Valuation Graph, which plots the median price/fair value ratio of our coverage universe over time. Back in November 2008, that ratio got as low as 0.55, meaning that the median stock was trading at barely half of its estimated fair value, and in early March it was still close to 0.60. Now, however, it's above 0.90, suggesting that the market as a whole is close to being fairly valued.

Yet, as Bergman also points out, some parts of the market are still quite a bit cheaper than others. At a sector level, the median health-care stock had a price/fair value ratio of 0.73 as of June 26, by far the lowest of our 10 industry groups. That's not too surprising, given that health care was among the worst-performing sectors in the recent rally, largely because of uncertainty about the effects of health-care reform. While the risks can't be ignored, bargain-hunters have plenty of opportunities here.

Another group that's relatively cheap is wide-moat stocks, or those that our analysts believe have significant competitive advantages. Wide-moat stocks had a median price/fair value ratio of 0.79 as of June 26, compared with 0.87 for narrow-moat stocks and 1.01 for no-moat stocks. This pattern is not very surprising, either; the recent rally was driven mainly by risky stocks, while predictable, stable names--a description that fits most wide-moat stocks--gained significantly less. (On the flip side, those wide-moat names held up better than their moat-challenged counterparts during the downturn.)

Be Wary of What's Hot
The flip side of hunting for bargains is being wary of whichever investments have been hot lately, because often those are among the worst investments to get into at a given time. The classic example is technology stocks in 1999 and early 2000; lots of people piled into these stocks near the market top, attracted by their eye-poppingly high returns, then got burned when the stocks plunged in price. More recently, in the second half of 2007, large-growth stocks such as Apple (AAPL) and Google (GOOG) put up huge gains,

put up huge gains, but those same stocks fell hard in the first months of 2008 after it became clear that we were in a recession.

For the same reasons, it's a good idea to be skeptical of the hottest investments in the recent rally. That's especially true because, as noted above, those hot investments have mostly been risky, highly cyclical investments, including some of the areas that got beaten up the worst in the second half of 2008. The best-performing stock-fund categories over the past three months have been the various emerging-markets categories and global real estate, while among fixed-income funds, high-yield and bank-loan funds have had the biggest gains. These economically sensitive groups are among the riskiest categories out there, with some of the biggest losses in 2008. Investors bid them up in the first half in anticipation of an economic recovery, but they could struggle if the recovery isn't as strong as expected.

Within domestic equity, bank stocks have posted big gains since early March as people realized that a complete collapse of the banking system wasn't in the cards. Those stocks were quite cheap back in March, according to our analysts' estimates, but they're now close to fairly valued, with very high levels of uncertainty. Energy and basic-materials stocks were also among the biggest gainers from March to June, but they're now about fairly valued.

Admittedly, these sectors aren't nearly as scary as tech or Internet stocks in early 2000, which were wildly overvalued by virtually any measure. But they're unlikely to replicate their great recent performance going forward, and somebody who buys these stocks expecting a continuation of that performance may be disappointed.

Don't Try to Time the Market
Of course, in the short term, it's entirely possible that banks and materials stocks could stage another big rally, and that health care could continue to languish. If there are any lessons to be learned from the crazy market gyrations of the past couple of years, it's that nobody knows for sure where the market is going, and that even when "experts" try to predict it, they're often wrong.

That's why, if you're planning to invest after sitting on the sidelines, it's a good idea to do so in a prudent and systematic way. Once you've decided which investments you want to be in, dollar-cost averaging is one good way to control your risk and take the emotion out of the process. Dollar-cost averaging is just another name for investing the same amount at regular intervals, but it tends to result in smoother and better returns than strategies that involve trying to time the market.

It's also important to be sure that any new investments you make don't skew your asset allocation too far away from where you want it to be, especially if you're adding more stocks after being in bonds and/or cash. This recent column by Christine Benz gives some essential tips for reviewing your portfolio.